Hangover

Is there something new in general market activity? Has something changed? The New York Times offered a perspective rooted still in the dot com explosion of 5 years ago. Of course this information does not figure into a trend following model, but as after the fact analysis, it is food for thought.


May 8, 2005
The Stock Market Is Still Pressing the Reset Button
By PAUL J. LIM

DEPENDING on whom you ask, the recent stock market sell-off can be attributed either to inflationary fears or to the slowing economy. But some people say it’s also tied to a longer-term problem facing investors: the fact that five years after the stock market bubble burst in 2000, unleashing one of the grisliest bears in history, there are still signs of froth.

“You might think that with the stock market significantly lower after all this time, investors would be chastened,” said Ben Inker, director of asset allocation at GMO, an investment management firm in Boston.

But it often takes six or seven years for returns to revert to their historical norms, he said. Despite the recent bear market – from its peak in March 2000 to its trough in October 2002, the Standard & Poor’s 500-stock index lost nearly half its value – blue-chip stocks have still posted average annual gains of 13.2 percent over the last 20 years, according to Ibbotson Associates, the investment consulting firm.

That’s well above the 10.4 percent average annual return that stocks have delivered since 1926.

Given that equities are coming off of one of the biggest bubbles in recent history, it may take much longer this time for stocks to reset to their norms. That may mean a prolonged period of below-average returns.

How much below average?

Mr. Inker has very low expectations for stocks. Over the next seven years, he predicts, domestic equities will deliver average annual returns of only around 1 percent. Assuming inflation of around 2.5 percent, that means a real return of minus 1.5 percent a year.

But haven’t stocks already lost more than 2 percent a year, on average, over the last five years? That’s true, but sometimes it takes more than a decade for stocks to get going after a big meltdown. After stocks peaked in the mid- to late 1960’s, for instance, the Dow Jones industrial average was virtually flat until 1982.

David Chalupnik, head of equities at the First American Funds, isn’t so pessimistic. He says he thinks stocks may gain 7 percent a year, annualized, over the next 25 years. But that is still around three and a half percentage points below stocks’ long-term average.

While he acknowledges that stocks have already suffered tremendous losses, he notes that many of the underlying economic attributes that led to above-average returns in the 1980’s and 90’s are likely to deteriorate. “From a productivity point of view, an earnings point of view, and a growth point of view, we’re starting from such a high point,” he said.

To be sure, a good deal of the market’s excesses have been wrung out. For example, the price-to-earnings ratio for the S.& P. 500, based on trailing four-quarter earnings, is around 19. That is down considerably from the 2001 peak of more than 46.

But Clifford S. Asness, managing principal at AQR Capital Management in Greenwich, Conn., relies on a different P/E ratio, one made famous by the Yale economics professor Robert J. Shiller, and finds that stocks are still historically expensive.

Mr. Asness has taken the current price of the S.& P. 500 and divided it by the 10-year average of trailing corporate earnings. By that measure, the S.& P. trades at a P/E of around 26. With the exception of the late 1990’s, the last time the market was this expensive was in the years leading up to the Great Depression.

Many investors may not want to hear that. “People have an almost moralistic view,” he said, “that they’ve endured such heck in recent years that things must be cheap in the stock market.” He said stocks were likely to gain around 7 percent annually – or 4 percent in real returns – in the coming years.

In some ways, that’s a relatively optimistic forecast. Mr. Asness has studied the market’s performance back to 1927, based on valuations. When stocks trade at 19.9 to 31.7 times their 10-year average real earnings – as they do now – they’ve typically lost 0.1 percent a year, in real returns, in the subsequent decade.

What does it all mean for investors? For starters, there’s a strong chance of another major bear market, or of more frequent corrections in coming years than we’re accustomed to facing.

The fact is, investors who cut their teeth in the 1980’s and 90’s were spoiled by unusually long bull markets. But since 1900, bull markets have lasted only 718 days – or roughly two years – on average, based on the gains in the Dow Jones industrials, according to Ned Davis Research in Venice, Fla.

The rally in the equity markets that started in October 2002 is already two and a half years old.

IF stock returns are lower in coming years, low-cost, tax-efficient investing strategies will gain popularity, says Harold Evensky, a financial planner in Coral Gables, Fla. Mr. Evensky says he believes stocks will return around 8 percent a year, on average, in the coming decade, with inflation averaging around 3 percent.

In such an environment, Mr. Evensky said, “if you can shave half a percentage point in taxes and half a percentage point in fees, you just saved 20 percent of your real returns.”

Ultimately, the best strategy for investors in a low-return environment is simply to save more money, says Rande Spiegelman, vice president for financial planning at the Schwab Center for Investment Research.

“We’ve gotten used to the market doing our savings for us,” Mr. Spiegelman said. “Hopefully those days aren’t over just yet.” But if they are, investors will have to pick up the slack.

Paul J. Lim is a financial writer at U.S. News & World Report. E-mail: [email protected]