Prominent Wall Street analyst Abby Joseph Cohen believes that 2003 will be remembered as a great year for the investment community, 2004 will be good but not fantastic, and that the stock market remains under-valued.
She provided long-term forecasts to Harvard Business School MBA students in remarks made November 19 to the student-run Finance Club. Although optimistic about the longer run, Cohen said she is concerned about the American trade deficit and acknowledged the uncertainties introduced by terrorism.
The famously bullish analyst tempered her enthusiasm with acknowledgement of the difficulties of past three years in American economic performance. But today, she said, "I believe very strongly that the U.S. economy is, indeed, back on its feet… It is recovering and soon it will be expanding."
Corporate profits have been improving, she said. "The year 2003, when history is written, will turn out to have been a great year for corporate profits: not just in terms of the profit margins, but also in terms of the cleanliness of the data that companies have provided to us. And that is an enormous improvement." Cohen said that during the late '90s she and most analysts had inaccurate assessments of the market because the work they were doing was based on "fictional data."
| Three years ago and for many years before that, we had a trade surplus with Europe. |
Cohen suggested that the U.S. stock market is still under-valued, but "obviously not as cheap" as it was earlier this year. "Investor risk aversion is somewhat above the historical median, which means that the market is still somewhat under-valued, but not dramatically so."
Next year is going to be good, not fantastic, she said. But stability is crucial.
In 2004, economic growth will be slower than it was in the first half of 2003, Cohen predicted. Third-quarter real GDP growth in 2003 was 7.2 percent. "Very nice but not sustainable," Cohen said. In 2004, she believes real GDP will be closer to 3 percent, maybe a bit higher. This development is part of the bull market's shift from what she called phase I to phase II. As the economy moves from 7 percent growth to 3 percent growth, there will be change in the equity market as well.
"That's the first phase of a bull market: The first phase is a sigh of relief. The first phase is one in which the equity risk premium that is embedded in share prices goes from a level of significant risk avoidance to more notable risk tolerance.
"In the second phase of the bull market, when GDP growth is slower than it has been and profit growth is slower than it has been, what matters is not the rate of change, but rather investors' confidence in the durability of economic growth—their confidence in the longevity of the cycle," she said. "What matters most is concerns and beliefs in whether policy will allow growth to continue; whether the underlying structure of the economy will allow growth to continue."
Now, the bad news
What concerns Cohen more is the American trade deficit. While most people know that the U.S. is the world largest importer, she said, they are not aware that the U.S. is also the world's largest exporter. The imbalance in economic growth between the U.S. and other major economies over the last two to three years helps to explain why the U.S. trade deficit has widened. This is important because the U.S. has a trade model that depends upon the vigor of other industrial economies, she said.
"We're not trying to compete with Mexico or China in the production of certain items. We're perfectly happy to import those items as long as we have an opportunity to redirect our most valuable resources, our people and our capital, to other activities with higher rates of return, which turn out to be higher value-added goods and services. Who are our customers? Our customers are other major economies, primarily in western Europe and Japan," she said.
Citing the most recent trade data, for the twelve months ending in August 2003, the most important trade partner for the U.S.—by region—was North America. "There's an awful lot that happens between Canada, the United States, and Mexico."
Outside of North America, however, the single most important trade partner is Western Europe. In the twelve past months, Cohen said, the U.S. exported approximately $160 billion worth of goods and services to Western Europe. During that same period of time, the U.S. imported $260 billion worth of "stuff"—for a trade deficit of $100 billion.
"From an arithmetic standpoint, this is more troubling to me than the roughly comparable trade deficit for China," she said. "Why? Because three years ago and for many years before that, we had a trade surplus with Europe. If you're looking to see where trade relationships have swung, it has been with Western Europe, not so much with China. We have been a net importer from China for a long time. Why has the trade situation with Europe deteriorated? Because we have been growing dramatically faster than have they. And they are the natural market for many of the products we make; and their domestic demand has been inadequate."
Long-term outlook
For her longer-term forecast, Cohen said that she and Goldman Sachs colleagues around the world believe that three main trends will probably take effect:
- The combined trading block of North America and Asia is most likely to offer the best longer-term investment opportunities. Some parts of Europe, including "emerging Europe," look appealing, but not as places that could receive large amounts of capital.
- Within the United States some of the longer-term structural problems have been fixed. "The productivity of our workers today is probably double what it was ten or fifteen years ago. It's a function of, we think, intense capital expenditure and a higher capital-to-labor ratio; but it also reflects better training, better education and other things that are environmental within the workplace," said Cohen.
- Inflation—"which used to be the big bugaboo,"—is not going to be a problem going forward. "Nor are we big believers in systemic deflation," she clarified.
"Now let me be very careful. When people talk about deflation, it's often one term used to describe two different things. Over the course of history, going back centuries, there is almost always deflation in commodity prices. Stuff gets cheaper. It gets cheaper to grow corn. It gets cheaper to extract minerals from the ground. It gets cheaper to produce manufactured goods.
"So there's almost always deflation in those categories—but the sort of deflation that we worry about, such as [happened] during the 1930s in the United States, or the 1990s in Japan, is not just commodity deflation. It's also a failure of the banking system and an overall decline in national income.
"We just don't see that. So, think of the inflation environment as being 'flation' overall, [with] deflation in commodities. But we do think that there's some inflation coming from differentiated goods and services and in some income categories," she said.
Cohen also said that China is not likely to become the powerhouse immediately that some of her Wall Street colleagues are predicting. Chinese markets are quite small, she said. Furthermore, she believes that the inevitable banking crises in China will probably make the one in Japan "pale by comparison." It will take a long time before there will be a lot of public investments available in China.
However, she added, "I do think that there are some wonderful opportunities. One of the ways to participate, not just in China but in other parts of Asia, is through foreign direct investment, venture capital, and investing in good quality companies in the United States, Japan, Korea, and elsewhere in Asia that are participating in the economic development of Asia."
While optimistic about the U.S. economy, in response to a student's question Cohen acknowledged that terrorism is a problem that she and her colleagues must factor into their analyses.
"There's no good or easy way for me to answer that question," she began. "What we often do in our work is a 'sensitivity analysis.' Let me share with you some of the conclusions from that. First of all, we would not rule out the possibility of a terrorist act, either here or somewhere else. What we do know, though, is that the United States tends to be viewed as the safe haven, properly or improperly, when such things happen. In years gone by, when there was a currency crisis in Asia, the United States was the safe haven. The dollar went up. The U.S. treasury went up. Our stocks went up, at least on a relative standpoint. When the former Soviet Union fell and when there was a coup overnight in Moscow, all the European markets and currencies collapsed. The dollar went up. U.S. Treasury market went up. U.S. equities went up.
| China is not likely to become the immediate powerhouse that some are predicting. |
"The surprising one is after September 11th. When our markets reopened, the dollar, the bond and the equities, were relatively stronger here than they were elsewhere. So that's one way we look at it.
"The second way we try to approach this is to think in terms of the impact of terrible acts on the equity risk premium. Clearly, after September 11th, we did see the embedded equity risk premium rise in our markets and in others. If history plays out, it is the first of the major disappointments, the major upsets, that creates that and after a while markets and economies don't become immune, but they become less susceptible. So that is certainly one possibility to look at, going forward.
"And the third thing that we have tried to do—but I have zero confidence in this because it's not my area of expertise—is to speak to people who do claim to be experts to give us some sense of what the likelihood is of these sorts of activities. And what we're basically being told is that the likelihood of a truly damaging terrorist attack has diminished in the United States, not necessarily elsewhere, but in the United States.
"I don't know if that is a complete enough response for you," she concluded. "It's the best that I can do. The one thing that we often look at anecdotally is the performance of the Israeli economy and the Israeli markets. Prior to the last two years, in fact, the Israeli economy and markets did quite well, even when there were terrorist attacks, because they were viewed to have an isolated impact. However, over the last year or two, the effects of terrorism worldwide and in Israel have led to a decline in tourism.
"In the United States, tourism from non-U.S. visitors has declined dramatically, but it's a fairly small percentage of our economy," she added. "That is not the case in Israel. So there is, in fact, a disproportionately large impact there which we think helps account for some of the problems."
The Wall Street strategist said that this was her fourth visit to speak to HBS students. "I was here for the first time before banking was cool. I was here twice when investment banking was the place to be. And I'm back again."