Large Cap Checks and Balances

Large Cap Checks and Balances
Changing Opportunities Highlight Landscape

By Dennis Trittin, Portfolio Manager
Russell Investment Group
Global Leaders in Multi-Manager Investing
March 12, 2004

On a macro basis, stock-market history has shown its tendency to repeat. But that doesn't mean 2004 will mimic 2003. Though we continue to experience broad economic recovery, investor confidence, and growth in corporate profits, Russell's money managers expect this year's performance to be of a different magnitude than recent history.

There have already been shifts this year in which large-cap styles and sectors are expected to outperform their benchmarks. Let's begin by looking at the positives and negatives of the current market, and attempt to understand what economic forces are currently at work.

Signs of the Times
One of healthiest signs we're seeing is that the economy is not just operating better, it's operating in balance. We've seen corporate profits rise not just in consumer sectors, but in industrials, technology and other sectors. Rather than showing substantial revenue growth, the key driver is profit margin expansion as companies have cut their costs to the bone.

Another encouraging sign for equities is that competition from fixed-income assets is weak by historical standards; stocks have a much lower hurdle to better the returns available in bonds. All this has made many corporations and investors feel it's time to take risks again.

There are some minuses, however, that may hold back stock appreciation. At present, interest rates are about as low as they're going to go. The next move the Fed makes will likely be to raise them; this typically affects price/earning multiples, and causes investors to be a little more risk-averse.

In addition, valuations may be limited on the top side. At the beginning of last year, low expectations had produced extremely low valuations for many issues. What followed, of course, was a year of phenomenal growth. While valuations have risen, so have expectations, and it can be difficult to beat higher estimates quarter after quarter. Companies like Intel have recently announced very strong earnings growth, but the market hasn't responded. This tells us that the stock was fully valued with such earnings expected, rather than having a depressed valuation where a little bit of good news can send the price through the roof.

There are three more factors that may impact companies' profit margins. One is rising costs from companies needing to hire again. When inventories were plentiful, companies were concentrating on reducing their surpluses rather than operations, laying off people as a result. Now that demand is improving and inventories are low, companies have to ramp up — and that means increases in such items as payroll, health care and pension expenses. The second is a technical factor: the growing tendency for corporate insiders¹ to sell securities once stocks have risen. Also, the market is high priced relative to the 200-day moving average, so investors shouldn't be surprised if we see a correction or two along the way.

Lastly, we have two wild cards to consider, which can either help investors' hands or lessen the value. One is the presidential election; any change to the recent investor-friendly tax bill, with its favorable dividend treatment, could dampen investor enthusiasm. Another is the value of the dollar; the question is whether its current decline is manageable or will require intervention by the Fed to raise interest rates in support.

Forecast: Rising Degrees
Add it up, and what level of return can investors expect? Most managers feel that the broad large-cap market in 2004 is likely to be moderately positive but not near 2003's 29.89% return for the Russell 1000® Index. Manager consensus indicates that much of the potential growth should come from quality issues. Last year's heroes were often managers who bought low-quality, high-risk stocks, which reached valuations that are no longer attractive. We're moving into an earnings phase of the market where companies must be able to demonstrate growth, which has managers moving up the capitalization spectrum to emphasize large-cap names. And unlike last year, we feel 2004 will not show a wide performance differential between large-cap and small-cap issues.

Because many companies no longer have compelling valuations, the effect of pricing has become more intense. Typically, it's the large-cap companies that have the most capability to withstand tough pricing environments. In addition, the decline of the dollar has helped large U.S. multinational companies gain market share overseas.

Russell money managers are already anticipating that as the year progresses, the more stable companies may move into the leadership position. It is likely to get harder and harder to show significant earnings growth, because profit comparisons will be much tougher in the second half. By contrast, the quality companies that lagged last year could look very appealing.

Getting Back To Basics
Are we seeing any particular sectors that stand out? None that would cause Russell managers to make significant sector bets. The defensive sectors are more attractive now than in 2003, but are still weaker performers as contrasted with sectors tied directly to the economy. And while we feel the strongest franchises within the tech sector may show outperformance as the year progresses, we don't believe it will be due to anything special they've done, but rather to their former high-flying competitors decelerating.

Rather, the word for 2004 is diversification. You can no longer be an indiscriminate buyer of low-quality/high-risk stocks and expect noteworthy performance. Achieving balance in your portfolio, and being selective with the issues you include, is going to be the key. And when you think about it, a return to normalcy can be good for everyone.

Copyright© Russell Investment Group 2004. All rights reserved. See Important Legal Information. Date of first use: 3/12/04.

¹ Insiders include major corporate officers, members of the board of directors, and owners of 10% or more of any equity class of securities. About six weeks after the reporting period, this insider trading information is made public by the SEC.

Nothing contained in this material is intended to constitute legal, tax, securities, or investment advice, nor an opinion regarding the appropriateness of any investment, nor a solicitation of any type. The general information contained in this publication should not be acted upon without obtaining specific legal, tax, and investment advice from a licensed professional.

Russell Investment Group is a Washington, USA corporation, which operates through subsidiaries worldwide and is a subsidiary of The Northwestern Mutual Life Insurance Company.

Past performance is not a guarantee of future performance.

Diversification does not assure a profit or guarantee against loss in declining markets.

Indexes are unmanaged and cannot be invested in directly.

Russell 1000® Index: Measures the performance of the 1,000 largest companies in the Russell 3000, representative of the U.S. large capitalization securities market.

Forecasting represents predictions of market prices and/or volume patterns utilizing varying analytical data. It is not representative of a projection of the stock market, or of any specific investment.

Copyright© Russell Investments 1998 - 2008. All rights reserved.

This is a publication of Russell Investments. Nothing contained in this material is intended to constitute legal, tax, securities, or investment advice, nor an opinion regarding the appropriateness of any investment, nor a solicitation of any type. The general information contained in this publication should not be acted upon without obtaining specific legal, tax, and investment advice from a licensed professional. Russell Investment Group is a Washington, USA corporation, which operates through subsidiaries worldwide, including Russell Investments, and is a subsidiary of The Northwestern Mutual Life Insurance Company.

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