Some market strategists think this global rebalancing act could be a 10- or 20-year process. But skeptics point out that an overseas financial crisis could erupt at any time and send investors fleeing to the relative safety of the U.S. markets —— not unlike what happened during the 1997 and 1998 Asian and Russian sell-offs.
Who's right？ Before we can sort out the possibilities, we must understand how the blue chips got so popular in the first place.
The biggest U.S. stocks returned an average of 16% a year during the 1982-2000 bull market, gains that far outpaced the underlying corporate profit growth. In 1981 the average price-earnings ratio for these stocks was around 8. By 2000, at the peak of the tech bubble that sent many stocks to all-time highs, it had swelled to 35. Even a conglomerate such as GE sported a ratio nearly double its current 18. Blue chips “are coming off the biggest p-e expansion in history,” says James P. O'Shaughnessy, who oversees more than $6.5 billion at Bear Stearns Asset Management Inc. （BSC ） “In 2000 it was as if there was nothing else worth investing in.”
Nothing indeed. The bull market resulted from a dearth of alternative opportunities. Long-term interest rates fell throughout the period, making bond yields less attractive to investors. Prices of oil, other commodities, and precious metals fell, too. Two housing busts soured investors on real estate by the mid-1990s. Stocks were the only game in town. The p-e ratios of companies with growing but stable earnings soared, with blue chips enjoying unprecedented popularity.
Then the profit growth stopped —— and with it, blue chip supremacy. According to Goldman, Sachs & Co., reported earnings per share of the companies in the S&P 500 fell from $50 in 2000 to $17.50 by 2002. The largest 100 stocks lost 53%, peak to trough. Assuming an 8% average annual return, it would still take Cisco Systems Inc. 17 years to hit its 2000 level； Microsoft, 10 years； GE, 8； and Disney, 6.
Smaller stocks have fared much better, for two reasons. For one thing, their valuations hadn't run up so much in the first place. And second, smaller companies are nimbler than big ones, and can adapt to changing economic conditions faster. As blue chip profits cratered in 2002, the earnings of the S&P 600-stock index of small capitalization companies rocketed 20%, then 15% and 28% the following two years. Investors sought out the relative value of small and midsize companies, which have returned an average of 15% and 13% a year, respectively, since March, 2001. Small caps once were considered much riskier than big ones. The big-company earnings crash showed that even the celebrated blue chips are risky, too.
The question is, which period was the aberration： 1982-2000 or 2001-06？ History seems to argue for the former. According to Ibbotson Associates, small caps have returned 11.7% annually since 1926, vs. large caps' 9.8%. As Herb Stein, chairman of the Council of Economic Advisers under President Nixon, once quipped, “if something cannot go on forever, it will stop.”
Hedge funds exacerbated the shift to small stocks. In 1982 they were minor players. But they took off in the late '90s and especially during this decade. Their superior information-gathering allows them to spot profit opportunities in small companies that aren't widely followed. The ability of so-called activist hedge funds to transform small companies by taking big positions and agitating for change has been another lure. Perhaps most important, hedge fund traders are trend followers, traveling in packs into and out of asset classes. Right now the trend favors small stocks. “If you were to stick a gun to my head,” says Bear Stearns' O'Shaughnessy, “I'd say small caps will keep beating for 20 years.”
It isn't only small caps that are dominating. Blue chips are getting crushed by just about everything overseas. South Korea was up 54% last year； Latin America, 55%； and Saudi Arabia, 108%. Russia and a resurgent Japan returned 87% and 42%, respectively. In the past five years, the S&P Citigroup Emerging Market Index has returned about 17% a year, slightly better than the annual returns U.S. blue chips posted from 1982 to 2000. Could emerging markets pull off a similar 18-year run？
Time was, investors looking for exposure to international and emerging markets would buy shares of a huge U.S. multinational, which supposedly offered transparency and sound governance and none of the crony capitalism found in emerging markets. Then the corporate scandals hit, and big U.S. companies were seen in a different light.
Nowadays, foreign pure plays are getting the benefit of the doubt over U.S. giants. For example, shares of Brazil's Banco Bradesco, which trade in the U.S. as American depositary receipts, have soared more than 370% since 2001. Citigroup's （C ） shares have gained only 12%, despite the bank's presence not only in Brazil but also China, India, Korea, Mexico, the Philippines, Poland, Russia, and almost 100 other countries. In all, Citigroup derived 41% of its 2005 net income from foreign markets. Yet investors clearly favor the Brazilian pure play.
It's difficult to argue with the growth these nations are posting. According to statistics from the International Monetary Fund, Brazil, China, India, and Russia drove 30% of the overall growth in global demand in 2005, more than double the figure five years earlier.
And so the hunger for international stocks is huge. Since 2003, net flows to international-stock mutual funds have more than tripled, to $150 billion, while flows into U.S. funds have plunged from $154 billion to $64 billion. In January, foreign equity funds' inflows almost doubled those of December.
The explosion of lower-cost exchange-traded funds （ETFs） has only hastened the advance, making it even easier for ordinary investors to jump into and out of emerging markets. Barclays Global Investors （BCS ） offers 37 international and global ETFs holding $72 billion in assets, up from 24 and $2 billion in January, 2001.
Some argue that emerging markets have emerged for good. “The structural story has changed,” says Thomas Melendez, associate portfolio manager at MFS Emerging Markets Equity fund, which has returned an average of 38% annually for the past three years. Emerging markets, he says, will keep growing, diversifying, and cleaning up their fiscal houses.
Consider the emergence of red chips, the biggest and best companies in China. They don't have the stability of their Western counterparts, and they carry the risk of major government intervention. But over the next several years, red chips should turn bluer. Demand for the initial public offering later this year of Industrial & Commercial Bank of China, one of China's largest financial institutions, is expected to be strong. Already, Goldman Sachs has ponied up $2.58 billion for a 7% stake, ahead of a potentially $12 billion IPO that's on track to be one of the biggest ever.
Yet despite the long rally, emerging-markets companies still trade below their historical averages based on p-e and price-cash flow ratios. “The [emerging-markets] story has legs for the next 10 years,” says Melendez. In fact, legendary value investor Warren Buffett, who made a fortune with big investments in blue chips such as Coca-Cola Co. （KO ） and Gillette, recently disclosed that he had made big bets on four major stock indexes, three of which are outside the U.S.
Whether or not you share that optimism, it's clear that big U.S. stocks face much more competition for investor dollars than ever before. With nearly everything else working, why should investors bother with blue chips？
Predicting the major turning points for markets has proved perilous for investors, academics, and business publications alike. But asset classes move in discernible cycles, rising and falling over long periods of time. Commodities, for instance, ruled the 1970s, slumped for two decades, and then resurged recently.
Strategists citing the cyclical argument have been predicting a blue chip comeback for 18 months. It hasn't happened yet. “Clients gripe： 'We listened to blue chip bulls last year, and it did not work,”' says Tobias Levkovich, chief U.S. equity strategist at Citigroup. “'[The bulls are] saying the same thing this year, and it's still not working.”' The degree to which blue chips have fallen out of favor is remarkable. “When we buy a large cap, we hear： 'How can you buy that dog？ It has done nothing for five years,”' says Ron Muhlenkamp, manager of the $3.2 billion Muhlenkamp Fund, which has big positions in several blue chips.
But betting against fund flows, prevailing sentiment, and trend lines has made contrarian investors rich over the years. “The time to make money,” said Lord Rothschild, “is when there is blood on the streets.” Big stocks are clearly wounded. “It actually hurts to say this again,” wrote ISI's Trennert in a Feb. 27 research note to clients, “but we believe large caps are due.”
Who's right？ Before we can sort out the possibilities, we must understand how the blue chips got so popular in the first place.
The biggest U.S. stocks returned an average of 16% a year during the 1982-2000 bull market, gains that far outpaced the underlying corporate profit growth. In 1981 the average price-earnings ratio for these stocks was around 8. By 2000, at the peak of the tech bubble that sent many stocks to all-time highs, it had swelled to 35. Even a conglomerate such as GE sported a ratio nearly double its current 18. Blue chips “are coming off the biggest p-e expansion in history,” says James P. O'Shaughnessy, who oversees more than $6.5 billion at Bear Stearns Asset Management Inc. （BSC ） “In 2000 it was as if there was nothing else worth investing in.”
Nothing indeed. The bull market resulted from a dearth of alternative opportunities. Long-term interest rates fell throughout the period, making bond yields less attractive to investors. Prices of oil, other commodities, and precious metals fell, too. Two housing busts soured investors on real estate by the mid-1990s. Stocks were the only game in town. The p-e ratios of companies with growing but stable earnings soared, with blue chips enjoying unprecedented popularity.
Then the profit growth stopped —— and with it, blue chip supremacy. According to Goldman, Sachs & Co., reported earnings per share of the companies in the S&P 500 fell from $50 in 2000 to $17.50 by 2002. The largest 100 stocks lost 53%, peak to trough. Assuming an 8% average annual return, it would still take Cisco Systems Inc. 17 years to hit its 2000 level； Microsoft, 10 years； GE, 8； and Disney, 6.
Smaller stocks have fared much better, for two reasons. For one thing, their valuations hadn't run up so much in the first place. And second, smaller companies are nimbler than big ones, and can adapt to changing economic conditions faster. As blue chip profits cratered in 2002, the earnings of the S&P 600-stock index of small capitalization companies rocketed 20%, then 15% and 28% the following two years. Investors sought out the relative value of small and midsize companies, which have returned an average of 15% and 13% a year, respectively, since March, 2001. Small caps once were considered much riskier than big ones. The big-company earnings crash showed that even the celebrated blue chips are risky, too.
The question is, which period was the aberration： 1982-2000 or 2001-06？ History seems to argue for the former. According to Ibbotson Associates, small caps have returned 11.7% annually since 1926, vs. large caps' 9.8%. As Herb Stein, chairman of the Council of Economic Advisers under President Nixon, once quipped, “if something cannot go on forever, it will stop.”
Hedge funds exacerbated the shift to small stocks. In 1982 they were minor players. But they took off in the late '90s and especially during this decade. Their superior information-gathering allows them to spot profit opportunities in small companies that aren't widely followed. The ability of so-called activist hedge funds to transform small companies by taking big positions and agitating for change has been another lure. Perhaps most important, hedge fund traders are trend followers, traveling in packs into and out of asset classes. Right now the trend favors small stocks. “If you were to stick a gun to my head,” says Bear Stearns' O'Shaughnessy, “I'd say small caps will keep beating for 20 years.”
It isn't only small caps that are dominating. Blue chips are getting crushed by just about everything overseas. South Korea was up 54% last year； Latin America, 55%； and Saudi Arabia, 108%. Russia and a resurgent Japan returned 87% and 42%, respectively. In the past five years, the S&P Citigroup Emerging Market Index has returned about 17% a year, slightly better than the annual returns U.S. blue chips posted from 1982 to 2000. Could emerging markets pull off a similar 18-year run？
Time was, investors looking for exposure to international and emerging markets would buy shares of a huge U.S. multinational, which supposedly offered transparency and sound governance and none of the crony capitalism found in emerging markets. Then the corporate scandals hit, and big U.S. companies were seen in a different light.
Nowadays, foreign pure plays are getting the benefit of the doubt over U.S. giants. For example, shares of Brazil's Banco Bradesco, which trade in the U.S. as American depositary receipts, have soared more than 370% since 2001. Citigroup's （C ） shares have gained only 12%, despite the bank's presence not only in Brazil but also China, India, Korea, Mexico, the Philippines, Poland, Russia, and almost 100 other countries. In all, Citigroup derived 41% of its 2005 net income from foreign markets. Yet investors clearly favor the Brazilian pure play.
It's difficult to argue with the growth these nations are posting. According to statistics from the International Monetary Fund, Brazil, China, India, and Russia drove 30% of the overall growth in global demand in 2005, more than double the figure five years earlier.
And so the hunger for international stocks is huge. Since 2003, net flows to international-stock mutual funds have more than tripled, to $150 billion, while flows into U.S. funds have plunged from $154 billion to $64 billion. In January, foreign equity funds' inflows almost doubled those of December.
The explosion of lower-cost exchange-traded funds （ETFs） has only hastened the advance, making it even easier for ordinary investors to jump into and out of emerging markets. Barclays Global Investors （BCS ） offers 37 international and global ETFs holding $72 billion in assets, up from 24 and $2 billion in January, 2001.
Some argue that emerging markets have emerged for good. “The structural story has changed,” says Thomas Melendez, associate portfolio manager at MFS Emerging Markets Equity fund, which has returned an average of 38% annually for the past three years. Emerging markets, he says, will keep growing, diversifying, and cleaning up their fiscal houses.
Consider the emergence of red chips, the biggest and best companies in China. They don't have the stability of their Western counterparts, and they carry the risk of major government intervention. But over the next several years, red chips should turn bluer. Demand for the initial public offering later this year of Industrial & Commercial Bank of China, one of China's largest financial institutions, is expected to be strong. Already, Goldman Sachs has ponied up $2.58 billion for a 7% stake, ahead of a potentially $12 billion IPO that's on track to be one of the biggest ever.
Yet despite the long rally, emerging-markets companies still trade below their historical averages based on p-e and price-cash flow ratios. “The [emerging-markets] story has legs for the next 10 years,” says Melendez. In fact, legendary value investor Warren Buffett, who made a fortune with big investments in blue chips such as Coca-Cola Co. （KO ） and Gillette, recently disclosed that he had made big bets on four major stock indexes, three of which are outside the U.S.
Whether or not you share that optimism, it's clear that big U.S. stocks face much more competition for investor dollars than ever before. With nearly everything else working, why should investors bother with blue chips？
Predicting the major turning points for markets has proved perilous for investors, academics, and business publications alike. But asset classes move in discernible cycles, rising and falling over long periods of time. Commodities, for instance, ruled the 1970s, slumped for two decades, and then resurged recently.
Strategists citing the cyclical argument have been predicting a blue chip comeback for 18 months. It hasn't happened yet. “Clients gripe： 'We listened to blue chip bulls last year, and it did not work,”' says Tobias Levkovich, chief U.S. equity strategist at Citigroup. “'[The bulls are] saying the same thing this year, and it's still not working.”' The degree to which blue chips have fallen out of favor is remarkable. “When we buy a large cap, we hear： 'How can you buy that dog？ It has done nothing for five years,”' says Ron Muhlenkamp, manager of the $3.2 billion Muhlenkamp Fund, which has big positions in several blue chips.
But betting against fund flows, prevailing sentiment, and trend lines has made contrarian investors rich over the years. “The time to make money,” said Lord Rothschild, “is when there is blood on the streets.” Big stocks are clearly wounded. “It actually hurts to say this again,” wrote ISI's Trennert in a Feb. 27 research note to clients, “but we believe large caps are due.”