Is This Really a Bear Market, Or Is It Some Other Animal?
By E.S. BROWNING
Staff Reporter of THE WALL STREET JOURNAL
EVEN THE MOST clueless of investors has noticed that the stock market is a different animal now than it was a year ago. The question is, is it a bear?
Figuring out if it is might be the key to any investor's success or failure in the stock market this year. And investors will be making that decision at a juncture when the market seems murkier, and more turbulent, than at any time in most investors' memories.
"I have seen estimates that we have erased $3 trillion in market value," says J. Thomas Madden, chief investment officer at Pittsburgh mutual-fund group Federated Investors. "That is a memorable amount of financial pain that has already occurred and which is undoubtedly having secondary feedback effects on spending and saving and the pace of the economy. There is plenty out there to give you pause."
On one level, it looks as if the bear is upon us. At the Nasdaq Stock Market, where most technology stocks trade, the composite index stands 48% below its record close of 5048.62 on March 10 of last year. If a bear market is a 20% drop from a high -- and that is the most common definition -- the Nasdaq is in a nasty, growling bear.
But what makes this time strange is that the general stock market hasn't followed suit, at least not yet. Although many companies are retrenching and announcing soft earnings, neither the Dow Jones Industrial Average nor the broader Standard & Poor's 500-stock index has fallen nearly 20% from its high; the Dow industrials finished last week's trading (the market was closed Monday for Martin Luther King Jr. Day) at a relatively tame 10% off the index's record.
It is the first time that market historians can recall seeing such a big sector -- technology, which at its height represented one-third of the market's value -- take such an enormous dive, and not bring the rest of the market down with it.
In some ways, the past year has felt like a bear market, the definitions aside. Most stocks just couldn't turn lastingly up. The industrial average has gone nowhere in more than a year. Its last record dates from Jan. 14 of last year. The climate is gloomy.
Still, a true bear market ought to feel uglier. Investors shouldn't just be grumpy. They should be disgusted. In a bear market, people hate stocks. They sell out and stop buying. Trading volume falls off consistently, instead of hitting records, as it did earlier this year.
"What would transform an undoubted crash in the Nasdaq -- and it is more than a bear market, it is a crash -- into a broad bear market, would be a real deterioration in ordinary investors' sentiment, a wholesale shift away from stocks and toward bonds and cash," Mr. Madden says. So far, although he sees people putting less money into mutual funds than before, he doesn't see them running for the hills.
So the debate now is partly about the ability of the tech sector to rebound, but it is deeper than that. It also is about the ability of the U.S. economy to stay out of a recession, and the ability of potentially troubled groups such as banks, insurance companies and energy producers to avoid following the tech companies into the tank.
So far, most experts, including Barton Biggs, the Morgan Stanley Dean Witter global strategist who presciently warned a year ago that something bad was on the horizon, say that there isn't yet confirmation that the broad stock market is in a bear market. That is because the major indexes still haven't fallen far enough. Mr. Biggs thinks this latest tech-stock rebound is a last gasp for the Nasdaq, before it sags again, pulling the rest of the market down with it.
Most of his competitors think the worst is over. With the Federal Reserve aggressively cutting benchmark interest rates and with incoming President George W. Bush promising to cut taxes, most strategists expect the stock market to pull out of its dive, even if the economy suffers a rough quarter or two between now and summer.
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What Song Is the Market Singing?
The three common scenarios of the status of the current stock market:
Don't Worry, Be Happy
We now are feeling the worst of the economic and stock downturn, and will avoid a bear market beyond tech stocks. This is the widespread view among Wall Street gurus such as Abby Joseph Cohen and Ed Kerschner. History also is on the side of this view. Although markets typically are nervous when the Fed first starts cutting rates, stocks tend to turn up after the second rate cut.
Oops, We Did It Again
The rate cut is coming too late and we are in for a deep bear market. This is the view of a minority, such as Barton Biggs. If they are right, that bodes well for stocks, since the S&P 500 today still is priced at a level way above historic norms, relative to companies' earnings.
Like a Rolling Stone
We are in a "rolling" bear market, in which different sectors are slammed at different times. Some investors point to the selling that most stocks endured when investors shifted money from the Old Economy and into tech. Their view is that most stocks, such as P&G, Coca-Cola and utility stocks, already have been through their bear markets. Thus, tech is just catching up or catching down) to what came before in the Old Economy. And perhaps the stocks that already have been through a bear market don't have to go through another.
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Investors trying to figure out whether a bear market is upon us will be keeping a close watch on the Fed's expected rate cuts, and on the reaction of blue chip stocks -- tech names such as Cisco Systems and Intel, as well as nontech stocks such as Citigroup and Alcoa. If the Fed aggressively cuts rates and the stocks advance, many will conclude that the worst is over, even if the economy and corporate profits remain sluggish. But skeptics warn that any rally risks becoming a "bear-market rally," destined to be crushed as investors grow impatient, since it can take the economy nine months or more to react to rate cuts.
Financial advisers typically advise long-term savers, who don't need their money right away, to tough out any bear market and stick with whatever financial strategy they have developed. Anyone who needs to spend the money soon probably shouldn't be in stocks in the first place. And, if the market ends up in a long, grinding slump as it did in the 1970s, any but the hardiest stock investors could be forgiven for losing heart.
One of the most fundamental debates in the market right now involves valuation. And the most simple way to measure how stocks are valued is to calculate how much people are paying for them, compared with the companies' per-share earnings.
A year ago, for example, "You were paying something like 25 times forecast earnings for Bristol Myers and 125 times earnings for Cisco Systems," says Michael Weiner, portfolio manager at Banc One Investment Advisors. "Now you are paying 30 times earnings for Bristol Myers and 40 times for Cisco. Maybe that is how it should be."
That brings the two companies more into line with reality. But what about the overall market? Overall, the S&P 500 is trading at around 24 times its companies' per-share earnings for the past 12 months. That still seems high, compared with an average of 16 since 1970, as measured by Ned Davis Research of Venice, Fla.
The bulls say that level isn't high at all, since inflation probably is 1% or less right now, compared with 10% inflation or more during parts of the 1970s. Taking inflation into account, the price/earnings ratio of the S&P could easily reach 30 without any problem, they say.
But what if we go into recession? Skeptics worry that P/Es could tumble. The median P/E during recessions since World War II has been 10, Ned Davis Research says.
In fact, as many as three differing scenarios can be found among the market experts, ranging from a nasty bear market to a strong bull market.
In the Grasp of the Bear
"The Nasdaq is not an isolated event," Mr. Biggs says. "The Nasdaq has a wealth effect on the American consumer, who is already incredibly leveraged up [indebted] anyway. And the Nasdaq has an effect on [information technology] spending, and IT spending and capital spending have been the motor behind the boom that we have had."
Bottom line: "I think that the Nasdaq is signaling that we are in a recession that is going to last a couple of quarters. That adjustment is going to fall on the Old Economy as well as the New Economy, so I think the Old Economy stocks will be affected too."
Instead of seeing earnings of the S&P 500 rise 5% to 10% this year, as most analysts currently are projecting, the bears figure the earnings could fall 10%. If so, that means that a lot more companies are going to be giving the stock market disappointing news, driving a wide variety of stocks down and pushing the Dow industrials and the S&P 500 into the requisite 20% declines from their highs.
And the Fed rate cuts? Too late to stave off recession, according to this view. "A recession," as Mr. Biggs puts its, "is baked in the cake."
The best that can be hoped, in this view, is that aggressive rate cutting by the Fed, together with a tax cut retroactive to Jan. 1, could soften the blow, making the recession, and the accompanying bear market, milder and shorter.
As it happens, some investors who don't expect a bear market were perplexed by the speed and the size of the Fed's rate cut this month. Some worry that the Fed might know of some deeper weakness in the banking system.
"One thing that would change my mind" about the risk of a bear market, "and a lot of people are watchful for this, would be some big financial problem," Mr. Madden says. So far, there isn't any sign of one, but "were that to crop up, then I think alarm bells would start to ring."
Skirting Disaster
When you look at a list of Wall Street's leading stock strategists, and find that just about all except Mr. Biggs expect us to escape both recession and a broad bear market, it gives you pause. Can so many people, almost all of whom failed to foresee the Nasdaq collapse, be right about this?
Their case rests in large part on a simple idea: "We wouldn't bet against the Fed. It is like betting on your alma mater to beat North Carolina in basketball," says Mr. Weiner of Banc One, a Carolina grad. "Since 1960, every time the Fed has lowered interest rates, stocks have done better. So the odds are that we aren't going to be in a bear market for all stocks," Mr. Weiner says.
Of course, Carolina's Tar Heels aren't invincible. Stocks did go briefly into a bear market in 1990, reversing the gains they staged after the Fed began lowering interest rates in 1989. But that case was complicated by the onset of the Gulf War. And the Fed arguably wasn't as aggressive then as it was earlier this month, when it acted between regular policy meetings to reduce rates by a higher-than-normal half percentage point.
In a nutshell, the bulls are persuaded that the economy won't suffer as much as Mr. Biggs and the bears expect. Corporate earnings will grow, although not as much as last year, say leading strategists such as Edward Kerschner of UBS Securities and longtime bull Abby Joseph Cohen of Goldman Sachs Group. Given how much the highest-valued stocks have suffered in the past year, that growth means that stocks can rise from here.
Laszlo Birinyi, founder of market-research firm Birinyi Associates in Westport, Conn., even maintains that recession wouldn't necessarily cause a bear market. Since 1945, we have had nine recessions, he says, but only five came at the same time as bear markets.
"Even if you think that we are in a good, old-fashioned recession, which we don't, earnings aren't likely to be down that much, especially with the Fed easing," Mr. Kerschner says. In a typical bear market, he says, rampant inflation prevents the Fed from cutting rates until the economy already has sunk into recession. This time, inflation has remained tame, permitting the Fed to act ahead of recession and stave it off.
"The Fed has made a V-turn in terms of policy and has become aggressively stimulative," Mr. Kerschner says. "So we aren't going to have a pattern of rising rates and falling earnings, which damns any economy."
Ms. Cohen calls the S&P 500 "moderately undervalued." Mr. Kerschner calls it 15% to 20% undervalued, making this "one of the five best buying opportunities in the last 20 years."
Been There, Done That
What if the bear market already has struck -- and it is over?
"We may already have had a bear market," Ms. Cohen says. "Certainly there has already been significant price depreciation in large sectors of the market. Do I think the S&P 500 will fall dramatically from current levels? It already has fallen substantially. We think it is undervalued, and we don't think we are entering into an economic Twilight Zone."
Some analysts think we have had a "rolling" bear market, in which different sectors went through bear markets at different times. Utilities, drug companies and makers of diapers, soda and household cleaners suffered in 1998 and 1999, for example, before the tech collapse. So did many older industrial companies.
"People forget that 40% of the S&P 500 in March 2000 was trading at 12 times earnings and less, and that is hardly a sign of notable overvaluation," Ms. Cohen says.
A year ago, many investors had gone overboard and forgotten business fundamentals, sending some stocks without profits to levels rarely seen for even the best-performing companies. Now, Ms. Cohen says, much of that air has been squeezed from the balloon.
"Before April 2000, share-price momentum was very important," she says. "What we see now is that it isn't. What is important is fundamentals -- sales, earnings, return on equity, valuation. That means that capital is being allocated much more efficiently."
Write to E.S. Browning at jim.browning@wsj.com |
