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From Liquidity to Earnings, the Recovery is Underway

Evidence is compelling that the U.S. recession ended in the fourth quarter of last year and a new economic expansion is well underway. The downturn was particularly painful for the manufacturing and technology sectors, putting a serious damper on corporate profits. However, the recession has proven to be one of the mildest on record.

Equity markets have responded differently to the good news about the economy. The S&P 500 and Nasdaq 100 indices have lost ground since the beginning of the year. In contrast, the S&P 400 Index, S&P 600 Index and Russell 2000 Index have been rising almost continuously since their September lows and are trading near their all-time highs.

Since September, several issues putting a damper on many large-capitalization stocks, namely accounting and transparency issues, have been fading. The economy has also been strengthening. As a result, we expect that the markets will begin to turn their attention to the shape and duration of the recovery and the investment opportunities it represents going forward.

This process will involve, either explicitly or implicitly, an assessment of the four pillars that form the underlying foundation of equity markets. We call these four pillars interest rates, liquidity, valuation and earnings.

Interest Rates

Higher credit demands are associated with a rebounding economy. Indeed, one of the most reliable economic relationships is the inverse connection between bond prices and economic growth. Not surprisingly, as the evidence of a solid recovery has grown, bond prices have increasingly experienced selling pressure. The yield on the 10-year government bond, for example, has traded as much as 30 basis points above its levels at the beginning of the year.

Bond markets are, indeed, transitioning from a two-year bull market to a cyclical bear market. And we expect pressure on rates to build. This will be ameliorated, particularly over the next six months, by favorable inflation and productivity numbers. However, the interest rate "pillar" will probably weaken before year end.

The next significant cyclical event for markets will be the Federal Reserve's increase in money market rates. This will mark the end of the central bank's aggressive easing cycle, which has probably driven rates below the appropriate equilibrium level. The market currently believes a Fed Funds rate increase is possible by June but more probable in August.

Factors that currently weigh against the Fed tightening liquidity include low inflation, idle productive capacity, high unemployment and weakness in profits and investments. Fed Chairman Alan Greenspan wants to see "sustainability of final demand," which, together with the other factors, may delay a move into mid or even late summer.

Excess liquidity will peak when growth in economic activity exceeds growth in money supply. The liquidity pillar will, given the current economic outlook, probably begin weakening this summer, possibly earlier.

We next turn our attention to valuation models and metrics, namely equity/risk premiums, dividend discounting and the bond yield compared to earnings yield. These factors suggest that equities today are neutrally valued, if not slightly expensive.

However, as the recovery progresses and liquidity peaks, the role of earnings expectations becomes central. We are near the beginning of such a transition.

The underlying trend in earnings expectations is up. Estimates have now been increased, both by analysts and by strategists, during the last three months.

The market probably does not now fully discount the profits gains likely this year and beyond, however. Undue pessimism has been dampening any hopes of an earnings rebound. Namely, market participants have been worried about the duration and shape of the recovery, pricing flexibility and productivity. Nonetheless, we expect the earnings pillar will strengthen during the year, particularly as markets increasingly look beyond 2002 and the current pessimism dissipates.

The Second Phase

Markets, when recovering from recessions, typically divide into two phases. In the first phase, a liquidity-driven period, monetary policy helps to stimulate the economy, price/earnings ratios rise and markets broaden. In the second phase, as the recovery begins to take hold, earnings improve and the Federal Reserve reverses course.

We will be transitioning into the second phase this summer and expect three key changes in the four pillars to ensure a recovery: weakening interest rates and liquidity; strengthening earnings; and resuming growth of stock valuations. As this occurs, equities increasingly become the asset of choice for investors.

Orie L. Dudley, Jr. is the chief investment officer of Northern Trust Co. of Chicago. This article originally appeared in Investment Management Weekly.