"New Reasons to Wonder if the Worst Is Over"
July 14, 2002
By TOM REDBURN
NY Times
HOW much worse could the worst bear market in a generation
get? A lot.
For some insight into just how bad things could still turn
out on Wall Street, it is worth paying attention to Robert
D. Arnott, managing partner at First Quadrant, a money
management firm in Pasadena, Calif., and co-author of a
provocative recent article in the Financial Analysts
Journal. It has the seemingly innocuous title, "What Risk
Premium is `Normal'?"
"The market has come down quite a bit from the
unprecedented levels it reached a couple of years ago," Mr.
Arnott says. "It has now reached the same valuation level
as at the market top in 1929."
That's right, the market top: before the crash that
heralded the start of the Depression, not afterward.
Mr. Arnott, whose view of market history extends a bit
further than that of most people on Wall Street (his
research examines the performance of stocks back to 1802)
doesn't really expect the kind of stock market collapse
that occurred from 1929 to 1933. And he certainly doesn't
expect the economy to fall apart; indeed, he is counting on
economic growth to average the same rate of the last three
decades.
But his study is a powerful reminder of just how over the
top the stock market became in the 1990's and how much more
downward adjustment may still be needed before prices
reflect a fair valuation of the earnings and dividends that
support them.
To reach that point, Mr. Arnott predicts, Wall Street may
have to endure a long spell - a decade or longer - in which
the stock market, while providing plenty of ups and downs,
repeatedly disappoints investors. "I would be very
surprised," Mr. Arnott said, "if bonds don't outperform
stocks over the next decade or so." Meanwhile, he added,
"The economy is probably going to be fine; it will just
take a decade or two to catch up with what the market had
anticipated."
Even as everybody from President Bush on down struggles to
restore confidence among investors who no longer trust
corporate earnings reports, the bitter truth is that stocks
may go up on a sustained basis only after they have fallen
far enough that investors are persuaded that they can go no
lower.
As James Grant, the editor of Grant's Interest Rate
Observer, wrote recently: "If U.S. stocks were absolutely
and unequivocally cheap, today's alleged crisis would be
self-correcting. Having fled an overvalued market, people
would be creeping back into an undervalued one."
The problem, to vastly simplify Mr. Arnott's complex
analysis, stems from the fact that investors in recent
years failed to resolve a fundamental contradiction.
On one hand, they seemingly forgot that stocks are
inherently riskier than bonds and began bidding up prices
in the market accordingly. That drove down the so-called
risk premium for holding stocks until it essentially
vanished. Yet at the same time, investors came to believe
that stocks - because they are supposed to reward investors
for taking extra risk - would continue to outperform bonds
and inflation.
YOU can't have it both ways indefinitely. When stocks were
priced at, say, 12 times earnings and offered dividend
yields of 4 to 5 percent, it was very easy to beat the
return from government bonds and inflation by 5 to 8
percentage points a year. But when the market, at its top
in 2000, was selling at about 35 times earnings and
dividends were yielding barely more than 1 percent,
investors could no longer expect to maintain such premium
returns.
David Bowers, Merrill Lynch's chief global investment
strategist, said in a recent report that "this sell-off has
not just been about the overvaluation of U.S. stocks."
"Rather, it has turned into a full-scale reassessment of
the attractiveness of stocks versus bonds," he added. "And
stocks have so far been the losers."
For the bull market to return, Mr. Arnott reasons, either
the stock market must fall even more or earnings and
dividends must soar. But his research found, contrary to
the conventional wisdom on Wall Street, that the growth in
earnings and dividends over the longer run cannot even keep
up with real economic growth per person, largely because
new enterprises rather than established companies account
for a significant share of the gains.
"Earnings growth will not keep pace with G.D.P. growth -
that's a really important insight," said David Levine, a
former chief economist at Sanford C. Bernstein.
Like everyone who tries to understand the market, Mr.
Arnott could turn out to be wrong about the future. But
even though, as he wryly acknowledges, "it is hard to get
rewarded for telling people what they don't want to hear,"
it pays these days to listen. |
