Some of the signs that blue chips were overvalued in the 1990s are showing up in small caps now. The Russell 2000 index sports an estimated p-e of 25, a 10-point premium to the S&P 100's 15. “What ultimately wins in financial markets is valuation,” says Trennert.
If valuation is king, cash is its queen. According to Moody's Investors Service （MCO ）, U.S. nonfinancial companies now hold a record $1.5 trillion of cash —— double the kitty of just seven years ago, with blue chips sitting on the most. Sooner or later, activist hedge funds will come a-calling. “The real [opportunity] is now untapped shareholder value,” says Trennert. “As in： 'Give the money back —— or else.”' Attacks on a few big companies might send their stocks up. And other big-company CEOs might start spending on share buybacks, dividends, and acquisitions, to nip potential activist challenges in the bud. Dividends, of course, can be a powerful component of total return. DuPont's （DD ） shares, for example, rose just 0.5% during the past five years. But adding and reinvesting dividends jack up the total return to 18.5%. For Microsoft, the numbers are 0.8% and 15.2%.
Rising interest rates would make those cash hoards all the more enticing. “If bond yields creep up, companies will be pressured to do more with their cash,” says Marc Freed, managing director of Lyster Watson & Co., a Manhattan hedge fund-of-funds shop. Investors would no longer tolerate idle cash languishing on balance sheets if it could be put to good use.
At the same time, rising rates would hurt smaller companies, which are more dependent on short-term borrowing. So while blue chips would be spending cash in ways to benefit shareholders, small companies could see their earnings decrease as their financing costs rise. That would change the perception of small caps as can't-miss investments, and prompt a shift back to blue chips —— the long-awaited flight to quality. Trend-following hedge funds would spot the turn faster than most, pile in, and speed things up even more.
Trennert takes the argument a step further. “The single biggest reason that large caps have lagged is that the economy hasn't slowed,” he says. “A slowdown would get people thinking about safe, sustainable earnings growth again.”
But what of the international funds and ETFs sucking so many tens of billions away from U.S. blue chips？ Levkovich says the trend simply can't last. While the relative valuation of the 25 largest S&P 500 companies, including recent winners ExxonMobil （XOM ）, Hewlett-Packard （HPQ ）, and P&G, is near a 20-year low, flows into emerging-market funds as a percentage of all equity flows is twice the previous peak. The last time he saw flows so disparate was during the last call for tech and growth stocks in 2000. “You can see the fad, and know it's just a matter of time until it blows up,” says Levkovich. “When people get worried, they will want the safety of U.S. equities.”
For a time, they will. But don't expect 2006 to kick off another 20-year blue chip bull market. One of the byproducts of globalization has been more efficient capital markets, with swifter and larger money flows. That poses a challenge for the millions of investors out there still fixated on big U.S. indexes. Stubbornly sticking with what used to work is a sure way to fail. “The 1990s spoiled us,” says Jeffrey M. Mortimer, chief investment officer for equities at Charles Schwab Investment Management （SCH ）. “All you had to do was show up.” Mortimer, who keeps his finger on the retail pulse by checking in on Schwab branches, says he's “shocked” by how hard old habits die. “They're looking east for the sunset,” he says.
“The reality,” says Edward Yardeni of Oak Associates Ltd., “is that we live in a much more competitive world than ever before.” Big U.S. stocks will have to duke it out with red chips, small caps, gold ETFs, and all the new issues that'll hit the scene in the years to come. What's the good news？ Increasingly complex financial markets mean more opportunities for investors —— and, if they're played right, fewer risks.
Bank on this： The blue chips will see another bull market, and perhaps soon. But with so many choices at investors' fingertips, the easy money may have already been made. Diversification is back. And that's not a bad thing.
If valuation is king, cash is its queen. According to Moody's Investors Service （MCO ）, U.S. nonfinancial companies now hold a record $1.5 trillion of cash —— double the kitty of just seven years ago, with blue chips sitting on the most. Sooner or later, activist hedge funds will come a-calling. “The real [opportunity] is now untapped shareholder value,” says Trennert. “As in： 'Give the money back —— or else.”' Attacks on a few big companies might send their stocks up. And other big-company CEOs might start spending on share buybacks, dividends, and acquisitions, to nip potential activist challenges in the bud. Dividends, of course, can be a powerful component of total return. DuPont's （DD ） shares, for example, rose just 0.5% during the past five years. But adding and reinvesting dividends jack up the total return to 18.5%. For Microsoft, the numbers are 0.8% and 15.2%.
Rising interest rates would make those cash hoards all the more enticing. “If bond yields creep up, companies will be pressured to do more with their cash,” says Marc Freed, managing director of Lyster Watson & Co., a Manhattan hedge fund-of-funds shop. Investors would no longer tolerate idle cash languishing on balance sheets if it could be put to good use.
At the same time, rising rates would hurt smaller companies, which are more dependent on short-term borrowing. So while blue chips would be spending cash in ways to benefit shareholders, small companies could see their earnings decrease as their financing costs rise. That would change the perception of small caps as can't-miss investments, and prompt a shift back to blue chips —— the long-awaited flight to quality. Trend-following hedge funds would spot the turn faster than most, pile in, and speed things up even more.
Trennert takes the argument a step further. “The single biggest reason that large caps have lagged is that the economy hasn't slowed,” he says. “A slowdown would get people thinking about safe, sustainable earnings growth again.”
But what of the international funds and ETFs sucking so many tens of billions away from U.S. blue chips？ Levkovich says the trend simply can't last. While the relative valuation of the 25 largest S&P 500 companies, including recent winners ExxonMobil （XOM ）, Hewlett-Packard （HPQ ）, and P&G, is near a 20-year low, flows into emerging-market funds as a percentage of all equity flows is twice the previous peak. The last time he saw flows so disparate was during the last call for tech and growth stocks in 2000. “You can see the fad, and know it's just a matter of time until it blows up,” says Levkovich. “When people get worried, they will want the safety of U.S. equities.”
For a time, they will. But don't expect 2006 to kick off another 20-year blue chip bull market. One of the byproducts of globalization has been more efficient capital markets, with swifter and larger money flows. That poses a challenge for the millions of investors out there still fixated on big U.S. indexes. Stubbornly sticking with what used to work is a sure way to fail. “The 1990s spoiled us,” says Jeffrey M. Mortimer, chief investment officer for equities at Charles Schwab Investment Management （SCH ）. “All you had to do was show up.” Mortimer, who keeps his finger on the retail pulse by checking in on Schwab branches, says he's “shocked” by how hard old habits die. “They're looking east for the sunset,” he says.
“The reality,” says Edward Yardeni of Oak Associates Ltd., “is that we live in a much more competitive world than ever before.” Big U.S. stocks will have to duke it out with red chips, small caps, gold ETFs, and all the new issues that'll hit the scene in the years to come. What's the good news？ Increasingly complex financial markets mean more opportunities for investors —— and, if they're played right, fewer risks.
Bank on this： The blue chips will see another bull market, and perhaps soon. But with so many choices at investors' fingertips, the easy money may have already been made. Diversification is back. And that's not a bad thing.