New Era For Stocks: Could be the end of a long, good run
by Kirk Shinkle
The Ups & Downs of the Stock Market
With a little luck, the economy and the stock market should hit bottom sometime this year.
In fact, there's a chance that both already have, although it certainly doesn't feel like it. It will be a pleasant moment when we begin to bid farewell to the housing and credit busts, the banking meltdown, and frightened consumers -- all sources of fear that kept Wall Street stomping on the "sell" button.
What emerges next, however, is anything but certain.
Undoubtedly, post-bust Wall Street will look very different than it did after previous recessions.
Chastened by regulators and stripped of long-standing opportunities for leverage, American companies, which have long been revered as the world's greatest profit engine, could be facing a prolonged stretch of tough times. Many analysts warn that long-term equity returns--the sort touted by financial advisers and analysts as an almost sure thing for much of the past two decades--could be based on outdated assumptions about the earning power of investing's most prestigious clubs: the Dow, the Nasdaq, and the S&P 500. "I would argue that we no longer have the kind of euphoria that caused the stock market to do as well as it did in the previous 20 to 30 years," says Andrew Lo, an economist at the Massachusetts Institute of Technology and a hedge fund founder. "We've experienced a rather dramatic shock and significant loss that has taken the steam out of [stocks]."
That means lots of rethinking will be required by all manner of market participants--companies trying to raise capital, investors planning retirements, pension funds facing large payouts--along with some difficult choices in a world where the search for a decent yield seems to get harder by the day.
Today's terrible stock market gets blamed on reckless banks, the housing bust, and all sorts of headline-grabbing culprits, but some of its woes predate the latest series of crises. Think back to the extreme excesses of the dot-com bubble's peak in early 2000 -- a period when overwhelming speculative optimism allowed the stock market to climb higher and faster than at any time in modern history.
The sheer scale of that run-up means that even after a "lost decade" of negative returns, equities may still not be cheap. Rather, they might still be working off a lengthy tech-bubble hangover.
Consider the relative scope of this bear market so far. From the peak of the dot-com bubble in 2000, the S&P had declined 58 percent as of March, based on the monthly average of daily closes.
That drop, which included the S&P's devilish low of 666, is still smaller than the declines during peak-to-trough bear markets that occurred from 1929 to 1932 and 1968 to 1982, when shares fell 81 percent and 63 percent, respectively.
Price-to-earnings ratios tell a similar tale
The historic monthly average P/E ratio, based on 10 years of earnings for the S&P 500, is 16.3.
In April, the average fell to 15.1 -- cheaper than usual, but hardly a value when compared with other periods of severe market disruption. For example, at the nadir of the 1982 downturn, the ratio fell to 6.6. Since economic damage in this downturn is expected to be far worse than it was in the '80s, the market's value could still be quite high.
Globalization and an end to the "Great Moderation."
Even before the market meltdown, worries that a quarter-century of economic stability might come to an end were beginning to surface. Starting in the mid-1980s, the United States enjoyed a long stretch of unparalleled productivity, low inflation, and tame market volatility, interrupted by only modest recessions. Economists dubbed it the "Great Moderation." An ensuing sense of calm bred increased risk-taking. As the cost of risk declined, financial institutions took more of it, opening themselves up to large-shocks risks that eventually appeared in the form of the credit bust. In the end, banks simply couldn't afford trillions of losses caused by outsized bets on derivatives (which were based on risky loans to thousands of American homeowners).
Globalization, for all its vast economic benefits, added a second wrinkle
As appetites for risk were rising in the United States, they were also spreading throughout the globe. An often overlooked feature of the past boom is that it was the first ever to rise and fall in a truly integrated global market. Optimists hoped traders from Singapore to Lisbon would spread risks and make markets more efficient. That did happen. But that interconnectedness also meant a far larger number of investors around the globe began operating on the same set of flawed assumptions (that U.S. housing prices don't fall, for example). In the end, global stock markets acted in tandem when financial turmoil hit, and many emerging market indexes fell even harder than their U.S. counterparts. In a 2004 speech, Federal Reserve Chairman Ben Bernanke, who was then a Fed governor, summed up the Great Moderation as a product of structural changes, better macroeconomic policy, and good luck. If that luck has run out, its demise could bring a return of higher volatility and lower asset prices.
Damage at home
American wealth declined by $11 trillion in 2008, and if we feel poorer for long, it will be a problem for stocks. Future equity gains are closely tied to the health of the U.S. consumer. For years, that was a good thing. Floating on that same wave of stability, unprecedented access to credit, and booming prices for major assets (stocks in the '90s, homes in this decade), the phrase "Don't bet against the American consumer" became something of a mantra for many investors despite stagnant wages and soaring levels of household debt.
At its peak, consumer spending soared to nearly 71 percent of GDP. Now many Americans are simply tapped out. Their recovery will be a big factor in determining when stocks will rebound. Unfortunately, consumer spending is closely tied to jobs, and once spiking unemployment reverses, some worry that those lost jobs may not come back. Recently, former Federal Reserve Chairman Paul Volcker warned of an extended "Great Recession" in which lost jobs in finance or the auto sector are not replaced, boosting the "natural" unemployment rate above the level of joblessness considered "full" employment today (about 5 percent) to something substantially higher.
At the same time, the financial crisis rages on
"Stress tests," bailouts, and executive bonuses still regularly top the financial pages, and the ultimate sign of success -- normalized lending -- is still probably a ways off. So, when might the financial crisis ease up? Not soon, according to research by Harvard's Kenneth Rogoff and University of Maryland economist Carmen Reinhart. They estimate a full recovery to pre-crisis levels could take four years.
Stocks often rebound before a recovery gets going, but this time other challenges remain. The problem could be prolonged by the aftermath of huge amounts of debt. "There is a debt overhang problem that we haven't solved here," Reinhart says. "I see it as a lasting damper on equity markets. It is in the financial companies, it is in the households, and it will be in the government."
They estimate the government deficit could increase by $8.5 trillion over the next three years, and Reinhart warns that such spending, when combined with billions more being spent around the globe on stimulus packages, could spur higher taxes and renewed inflation, which eats away at all manner of investment gains and produces historically poor returns for stocks. Looking ahead, she warns that the damage from our banking crisis that rippled around the world could come sloshing back if eroding emerging market economies face banking crises of their own.
Reasons not to love stocks (as much)
Wall Street trouble always brings out the bears, but this time the pessimists are getting more of a hearing, including those who think the current weakness in stocks is just getting started.
Martin Weiss, author of The Ultimate Depression Survival Guide, advises investors to abandon stocks altogether. Other longtime bears like Jeremy Grantham say subpar market returns could last a biblical seven years as consumers and businesses reckon with a long-lasting debt overhang.
The long-term value of slavish devotion to holding shares is being debated as well. A much-discussed paper published by Robert Arnott of Research Affiliates challenges the assumption that the "risk premium" that comes with stocks may be slimmer than many investors believe.
The other two key parts of a healthy market -- dividends and earnings -- also look a bit unappealing
During the '20s and '30s, dividend yields averaged 5 percent to 9 percent. They are much less generous now. The current 12-month dividend on the S&P is just 3.42 percent, which is below its historical average, and dividend payouts are expected to fall through 2010. And while first-quarter earnings were indeed better than many analysts expected, often gains came from cost cutting (including job reductions) rather than meaningful revenue growth.
In an average recession, Citigroup says, global earnings historically fall 25 percent from peak to trough.
As of April, earnings had already passed that mark with a 29 percent drop, but the severity of this downturn could push global earnings down by 50 percent. If markets do moderate for a long time, companies will be forced, at the very least, to come to terms with less access to capital.
Start-ups entering the market with lucrative initial public offerings dried up almost entirely this year, and they are unlikely to return to lofty levels soon.
Liquidity may have returned to precrisis levels by some measures, but the sort of lending that spurs outsize growth is still a ways off. "Companies have historically thrived thanks to cheap credit. Because that's been taken out, we have to expect more modest returns from equities," says Matt Rubin, director of investment strategy at wealth adviser Neuberger Berman.
With the onset of boomer retirement, pension funds would face some tough choices in a weaker market
The funds -- the aircraft carriers of the financial fleet -- are already wrestling with the troubling prospect that returns may not be as generous as they had hoped.
That could spawn more risk-taking by funds, not less. MIT's Lo, who manages a hedge fund, says many will return to hedge funds, private equity, and other alternative investments in a scramble to boost their returns. He predicts a wave of money pouring out of mundane stocks and bonds and into riskier assets that promise higher returns will add another strain to stocks.
"Over the next year or two, we may see more financial market gyrations because of these assets sloshing around from one segment of the investment industry to another," he says.
A more rational view of risk
In some ways, a tamer stock market could be a good thing. There is a sort of indirect benefit from an end to equity mania.
For companies, reliance on funding outside of the stock market could mean less frantic scrambling to manage their businesses under the yoke of unrealistic pressure to meet quarterly earnings projections. For everyday investors, a realization that the idea of equities producing highly stable profits is simply naive will hopefully prompt more Americans to rethink debt and risk.
While most financial planners are still extolling the virtues of stocks -- even in the midst of a recession -- Zvi Bodie is telling retirement-age investors to run the other way. The Boston University and MIT finance and economics professor says any investor who doesn't have the heart of a high-stakes gambler should pull his or her nest egg out of the stock market and shift retirement money ...
Basic materials stocks sound about as exciting as freshly laid asphalt, but they've become a steaming-hot investment in 2009. This group was devastated last fall as hedge funds abandoned the then-dominant thesis that the world -- especially Asia -- needs to keep building, and summarily dumped the stocks. However, ambitious economic stimulus packages in the U.S. and abroad have revived the need for basic materials.
Emerging markets are like those giant slices of double-mud chocolate-brownie cake offered to you by restaurant servers at the end of your meal. You run the risk of a severe stomachache later, but they sound so good it's hard to resist.
(c) 2009 U.S. News & World Report