Charging Ahead

The bull market in U.S. stocks is entering its seventh year. From its very beginning, this rise has faced persistent skepticism from many financial experts who doubted that it was anything other than a temporary bubble. Paradoxically, the mere longevity of the rise is now unnerving many investors, as is the magnitude of the gains.

It’s no wonder that the average person watching this spectacle might be perplexed.

Unlike many other stock market strategists, I have been optimistic for the last six years. I do not believe the continuing strength of the stock market, which reached an all-time high on Dec. 27, is an optical illusion. Rather, it has been firmly based on extraordinary changes in the economy that have given us one of the longest economic expansions in U.S. history. The U.S. economy has reestablished itself as the world’s strongest. Our workers are the most productive, our businesses the most profitable, and we are investing in new technologies and creating new jobs at an unrivaled pace.

It is easy to lose sight of these fundamental strengths, particularly when near-term economic data are confusing or the markets are volatile. But a key to successful investing is to filter out this noise.

This bull market has been one of the best in U.S. history, and it is likely to continue, for several good reasons:

* The economic expansion that has propelled stock prices higher has been one of the most durable. It has been accompanied by mild inflation, job creation and high-quality profit growth.

We’ve dubbed it the “Silly Putty,” or stretched-out, cycle, and we expect it to continue.

* The current economic and market cycles have benefited from several long-term structural changes for the better. These include an increase in the nation’s savings rate and a notable reduction in the government’s budget deficit, to less than 2% of national income or gross domestic product, from 6% in 1991. Furthermore, the shift to a more sophisticated, technology-driven private sector has spurred widespread productivity gains, and this offers new opportunities for growth and jobs.

* This bull market began with stock prices significantly undervalued relative to how well the economy and individual companies were performing. Prices have risen as this gap between favorable reality and skeptical investor perceptions was closed.

Most bull markets end when stocks are overpriced, not fairly priced as they are now. Stock prices can continue to rise in 1997 in concert with the improvement in corporate earnings and cash flow.

My colleagues and I expect this to continue at a less exuberant pace than was seen in 1995 and 1996 because there is no longer a valuation gap to close. Without meaning to sound overly precise, I expect the Dow Jones industrial average to reach 7,050 before 1997 ends--a gain of about 10%, or roughly half the increase it saw for 1996.

This projection is intended to give a sense of direction rather than a specific price target. It conveys my belief that the underlying economic strengths that have boosted stock prices remain intact.

The key to future stock price gains will be the ongoing performance of the economy. Measurable economic improvements, including smaller government deficits and substantial business investment in new technologies, have played an important role. But so too have factors that represent a fundamentally different economy from the one many of us grew up with.

Perhaps the most important change has been the reduction in not just inflation itself, but in expectations for inflation.

When inflation is high and rising, consumers and businesses make decisions that tend to perpetuate inflation and boost the rate of economic growth, but that also force an early end to that growth.

Consider typical household behavior in the late 1970s. Families would respond to the rises in supermarket prices by buying in anticipation of future increases. Cupboards were stuffed with paper and canned goods, and even big-ticket items such as autos and houses were purchased with the idea that prices would be rising further.

The result was an economy that grew faster than it otherwise would have. Price increases were passed along and the effect was intensified.

Accelerating inflation worried investors and members of the Federal Reserve Board. During the late 1970s and early 1980s, interest rates were raised to unprecedented levels in a protracted and painful effort to slow the economy and halt the inflationary spiral. Equities became so cheap that they were selling at less than half the cost of rebuilding each company’s physical assets.

How things have changed!

In the 1990s, low inflation and expectations for low inflation have meant great resistance to price increases. Consumption growth has slowed and the savings rate has risen, perhaps spurred by increasing confidence on consumers’ part that the value of savings will not be quickly eroded by inflation. Businesses watch costs quite carefully and do not overbuild inventories. Indeed, the inventory-to-sales ratio is the lowest ever seen in the United States.

We have an economy that is growing at a slower pace, but for longer.

Profits have more than doubled during the current economic expansion, helping explain the magnitude of the rise in stock prices.

At the same time, the U.S. economy began to transform itself more quickly toward more sophisticated manufacturing and high-level services. Corporations have restructured their operations massively over the last decade. The process has been a painful one for many individuals and families, but the ultimate economy-wide result has been to move corporate capital away from older facilities and toward operations that can generate both profits and jobs.

About 10 million jobs have been created over the last five years. Many are in industries and involve functions that are relatively new, and they pay above-average wages.

The profits now being reported by U.S. companies are of the highest quality in many years, because there is little inflation “padding” and accounting has become increasingly conservative.

The dramatic improvement in corporate profitability has come at a time of increased willingness by individuals to save and invest.

The 1970s offers an interesting contrast. Many of the baby boomers, members of the largest population cohort in U.S. history, entered their prime spending and borrowing years during that high-inflation period. New families were formed, and spending on housing surged, as did the willingness to borrow. Household balance sheets showed a strain--that is, many individuals borrowed too much given their financial circumstances--and the savings rate fell. Household wealth typically consisted of tangible goods such as real estate and precious metals that were viewed as inflation hedges, along with short-dated financial instruments such as money market mutual funds. Equities declined to only 18% of the typical household’s financial portfolio in the 1980s; that compares with almost 45% of the portfolio in the late 1960s.

Many baby boomer families are now in their prime years for saving and investing as they prepare for long-term goals such as retirement or children’s educations. Long-dated financial assets have thus become more appealing.

The decline in inflation, changes in the tax code in 1986, and the fact that the boomers already own homes have further reduced the appeal of tangible investments.

At the same time, many U.S. corporations have changed the kinds of retirement programs they offer to their workers, shifting from the traditional pension plan to approaches such as the 401(k), which require employees to save money themselves and, often, decide how it is to be invested.

Today’s working population is expected to take much more responsibility for its investment decisions, both through work and as private individuals, than was the case in years past.

As the bull market enters its seventh year, stocks are no longer undervalued and their prices have become more volatile. Our recommended portfolio for professional investors now suggests putting 60% in equities, compared with 70% to 75% in late 1994 and 1995. Yet we believe that further stock price gains will have a sound basis in the slower-moving but more durable economic expansion--this is an expansion that has thus far avoided the usual worrisome excesses such as bulging inventories, tight capacity utilization and the dreaded inflation that typically follows.

But the Fed and investors will be watching.

On several occasions since 1991, signs of accelerating economic growth have prompted temporary inflation concerns, higher interest rates and stock price volatility. But these have been transitory. Stock prices became trapped in choppy trading ranges only to move higher when the fundamental strengths reasserted themselves.

At some point, inflation will become truly problematic, but this is not likely to occur in 1997.

Finally, there is the rather different risk that other major world economies will grow so slowly in 1997 that U.S. economic and profit gains will be impeded. Several major foreign economies are now decelerating, Japan, the world’s second-largest, among them. Continental Europe has been unable to generate resilient economic activity, and unemployment is at high levels.

It appears that the U.S. economy will again be the global leader in the creation of jobs and profits in the coming year.