1985--A Year of Easy Money in Stock Market : Dow Surges to Its Best Annual Gain Since 1975

Making money in stocks was easy in 1985. Lower interest rates, low inflation, takeover fever and other factors helped the Dow Jones average of 30 industrial stocks rise 27.66%, its best yearly gain since 1975. Thirty-two record highs were set. Stocks in nearly every industry rose. Gainers led losers by 1,957 to 356--better than five to one.

The festivities were not confined to the United States. Traders in Tokyo, London and other foreign markets also toasted healthy stock gains.

Many traders, analysts and money managers expect the bull market to continue upward through the rest of the decade. Some even predict that the Dow average will rise to nearly 2,000 this year and double to 3,000 by the year 1990--up from 1,546.67 now and the record closing high of 1,553.10 set Dec. 16. Such a twofold rise would match the market’s gain since August, 1982, when the Dow stood at a measly 775.

However, experts caution, the market is also due for one or more downturns this year. Contending that stocks have become overpriced, some analysts predict that the market could fall by more than 10% sometime this year before resuming its upward trend.

“The market has been propelled by a lot of good news. But there’s not much tolerance for disappointments” such as poor corporate earnings or slower-than-expected economic growth, says Thomas J. Foster, research director of Wedbush, Noble, Cooke, a Los Angeles-based brokerage.

But, while the market may slip somewhat during this year, the factors that fueled last year’s phenomenal rally still remain in force and are seen by many market watchers as fueling a long-term bull market.

Lower interest rates are expected to continue making stocks attractive against money-market investments such as Treasury bills or bank accounts. They also spark optimism that the economy will improve from its estimated 2.4% growth rate of 1985.

If rates decline further, such as three-month Treasury bill rates dropping to 6% from the current 7%, “you’re going to see a rip-roaring stock and bond market,” predicts Werner Keller, director of research at the Los Angeles-based brokerage of Bateman Eichler, Hill Richards.

Optimism about lower rates has prompted many analysts to recommend stocks in such interest-sensitive industries as banks, savings and loans, insurance and housing.

But a rise in the Treasury bill rate to 8% could trigger at least a 10% to 15% slide in the market, says Elaine M. Garzarelli, director of sector analysis for Shearson Lehman Bros. She notes that every double-digit sell-off over the past 20 years has been preceded by a 20% rise in the Treasury bill rate. An 8% T-bill rate would represent a 20% rise from the low of 6.7%.

No Tightening of Money Supply

Another positive is low inflation. This has made stocks, bonds and other financial assets relatively attractive against such inflation hedges as real estate and precious metals. And as long as inflation stays low, the Federal Reserve will not tighten the money supply and throw the economy into a recession, analysts contend.

Many Wall Street analysts say declining interest rates, low inflation, a fast-growing money supply and falling dollar will boost 1986 economic growth to above the 2.4% rate estimated for 1985.

Consequently, many analysts are recommending stocks in such “cyclical” industries as chemicals, metals and paper, which will benefit disproportionately from a continued strong economy.

However, some analysts, such as Robert M. Hanisee, research director at Los Angeles-based Seidler Amdec Securities, predict that the recovery will run out of steam and that a recession will begin as early as the first quarter of 1987. Evidence of such a recession will show up as early as mid-1986, triggering a major market downturn, he predicts.

If the economy turns in a respectable growth rate as most expect, corporate profits should expand. David Blitzer, chief economist for Standard & Poor’s, expects earnings for firms in S&P;’s 500-stock composite index to rise 18% this year over 1985. That would be a marked improvement over what S&P; expects for 1985 compared to 1984--a 2% earnings decline or, at best, no change.

Higher expected earnings already are a major reason why stocks of blue chip multinationals such as International Business Machines and General Electric have led the current market rally. These firms benefit from the decline in the dollar, which makes their foreign earnings worth more in U.S. currency. The falling dollar is also a reason why some analysts are recommending stocks of soft-drink firms and others with extensive foreign operations.

The market should continue to benefit from the declining supply of stocks. The rash of mergers, leveraged buy-outs, stock buy-backs and corporate restructurings has removed billions of dollars of stock from the market. Only a fraction has been replaced through issuance of new equities. The Federal Reserve estimates that the net outflow of stock totaled $75.5 billion in 1985, following a $77-billion outflow in 1984.

As a result, investors have fewer stocks to choose from, and that has boosted prices. However, that trend will reverse somewhat as high stock prices encourage companies to issue new stock, argues the New York investment house of Salomon Bros.

While supplies of stocks have been shrinking, demand has been growing from various sources, including individual retirement accounts, mutual funds, pension funds and foreign investors.

Sales of equity mutual funds will total a record $26 billion in 1985, up from the old record of $21 billion during the 1983 bull market, the Investment Company Institute estimates. Traders also expect a surge in new funds from the estimated $50 billion to $70 billion in new IRA money this year. With low interest rates, IRA holders seeking double-digit returns will plop money into stocks or bonds rather than bank certificates of deposit, many analysts reason.

Blue Chips Lead Way

The low level of speculative activity also indicates that the market is not nearing a peak, many analysts believe. They say the most recent rally--which began on Sept. 23, the day after the United States and four other major industrial nations initiated actions to lower the dollar--has been led by gains in blue chip stocks such as IBM on the Big Board rather than “secondary” issues of smaller companies or lower-priced stocks on smaller exchanges that often generate more excitement because of their potential for higher gains.

“Boring is beautiful,” says A. Marshall Acuff Jr., portfolio strategist at Smith Barney, Harris Upham & Co., noting that action in speculative secondary stocks typically signals that the market is nearing a peak.

Indeed, since late September, the 19.2% rise in the Dow--which is exclusively blue chips--exceeded the gains in the American Stock Exchange market value index (up 10.3% in that same period) and the National Assn. of Securities Dealers Automated Quotations (NASDAQ) index of over-the-counter stocks (up 14.3%). It also outperformed such broader indexes as the Standard & Poor’s 500 (up 15.9%) and the New York Stock Exchange composite index (up 14.8%).

For the full year, the Dow’s 27.66% gain outperformed all of these indexes except for the NASDAQ index, which rose 31.4%. However, by year-end, the NASDAQ index still had not made up for losses incurred during late 1983 and 1984. It closed 1985 at 324.93, off its July, 1983, peak of 328.91. (As for other indexes during all of 1985, the Amex rose 20.5%, the S&P; 500 jumped 26.3% and the NYSE composite jumped 26.2%).

Some secondary stocks are notable for their price declines since the first half of 1983. High-technology issues traded in the over-the-counter market are off 60% to 70% since their peak in June, 1983, Bateman Eichler’s Keller says.

Accordingly, he and many other analysts are bullish on technology stocks, arguing that they are undervalued and that many firms stand to benefit handsomely from cost-cutting moves during the industry’s shakeout of the past two years.

But some analysts say the rally has already begun to spread to secondary issues. Some biotechnology stocks, such as those of Cetus and Genentech, have shown sharp rises in recent weeks, notes Norman G. Fosback, president of the Fort Lauderdale, Fla.-based Institute for Econometric Research, which publishes several investment newsletters.

Last year’s rally was characterized by buying from institutions, and “the public isn’t in the market to any great extent,” says Donna Hostetler, research director for the Los Angeles brokerage of Crowell, Weedon & Co. Individuals tend to favor secondary stocks while institutions favor blue chips, analysts say.

However, the individual “must come in” to keep the rally going, Bateman Eichler’s Keller argues. “The individual is a long-term investor,” he says, and without the individual, the market will simply be a forum for institutions acting “like poker players, shuffling money back and forth.” The short-lived mid-1984 rally didn’t hold because the individual never came in, Keller contends.

Insider Buying a Plus

Another bullish factor cited by newsletter publisher Fosback is a high level of stock buying by corporate insiders. This insider buying, he says, is particularly strong in interest-rate-sensitive stocks such as banks and other financial institutions.

Stocks in most industry groups sustained gains in 1985. Only 10 of the 82 stock groups tracked by Standard & Poor’s showed declines through trading of Dec. 24 (full-year results were not available at press time). The losers were led by offshore drilling (off 37.7%), crude oil (down 15.6%), communications equipment (off 12.4%) and agricultural machinery (off 10.5%). Winners were led by apparel manufacturing (up 86.2%), entertainment (86.1%), broadcasting (66.5%) and specialty retailing (62.7%).

But, while low interest rates and other factors point to a sustained bull market and continued strength in some of these groups, market analysts caution that some bearish signs are appearing, too.

“A few cracks in the bull-plated armor are finally beginning to show,” Fosback says.

One bearish factor is declining yields. Yields, which measure the percentage return on stocks from dividend pay-outs, have declined during the past year. Increases in dividends have simply not kept up with increases in stock prices.

The average yield on the 30 stocks in the Dow Jones industrial average now stands at only 4.1%, down from 4.9% last May, Fosback says. The average yield on stocks in the S&P; 500 are down even further, to 3.8% from 4.4% last May, he says.

A range of between 4% and 4.5% is normal, he says. A rate below 3.5% “would be of great concern,” he says, noting that when yields fell to that level in the late 1960s, a prolonged bear market ensued.

Another bearish factor is rising price earnings ratios, which measure the multiple of stock prices over earnings per share. Stocks are considered less of a bargain as price earnings ratios rise.

Stocks on the NYSE now have an average price earnings ratio of 14, while the average for the Amex is 15. That is approaching their highs of the past 15 years, Fosback says. “The market can support those levels only if earnings rise,” he says. If not, price earnings multiples could go back into the single-digit range, he suggests.

Disappointing Earnings Seen

Some analysts and money managers contend that earnings will in fact turn out to be disappointing. Stanley A. Nabi, a senior member of the investment policy committee of Bessemer Trust Co., a New York firm managing $4 billion in funds, predicts that 1986 will see a “baby bear” market because of disappointing corporate earnings and economic growth. (Nabi, however, is bullish in the long run. He predicts a 3,000 Dow industrial average by the year 1990.)

Even more bearish is Ian McAvity, publisher of a Toronto investment newsletter. He predicts that the Dow will decline between 25% and 30% this year, reasoning that the typical bull market lasts only about four years and thus this one “essentially has run its course.”

He and some other analysts also contend that stock prices have been run up artificially high on takeover speculation and actual mergers and stock buy-backs. Indeed, the investment banking house of Goldman, Sachs & Co. contends that 70% of the market’s rise since the beginning of 1984 is due to the merger wave.

Many analysts are urging investors to avoid broadcasting stocks because they have been run up too high by takeover speculation.

“If you take the takeover game away from the market, you finish the market off,” McAvity says.

1985 Dow Jones 30 Industrials

Open 1,198.87 High Dec 16 1,553.10 Close 1,546.67 Low 1,184.96