How Low Can They Go? The Markets Might Get Mean
By Fred Barbash
Sunday, December 3, 2000; Page H01
Last year's big question was: How high can the markets fly? We got some fantastic answers, ranging from 36,000 to 100,000 for the Dow.
We in the press duly reported those projections. Then they became laughable. Surely there's some connection.
In hopes that there is a causal relationship between our heralding predictions and their not coming true, allow me to report a few of the more radical answers being given to this year's big question: How low might the markets go?
Some respected statistical analysts think it could fall an additional 40 percent to 50 percent. That would put the Dow Jones industrial average at about 5000, where it was in 1996. The Nasdaq composite index would revert to about 1300 to 1600, its range in 1997.
Others predict the markets might go into an extended hover around today's levels, with equity prices staying flat for eight or 10 or even 15 years.
When could all this happen? That's where forecasters are frustratingly imprecise.
But since I've already described, in a previous column, the bright side of forecasting, such as Ralph Acampora's prediction of a bull market through 2011, it would be wrong to ignore the dark side.
Don't say I never warned you--of everything.
The predictions cited above are based on academic assumptions that markets revert to historical means. Markets go sharply up and sharply down from year to year, but over the long run they return to their statistical average of growth.
By definition, "mean reversion" requires an abnormally highly priced market to fall in order to return annualized average gains to a much lower norm. Conversely, abnormally low markets must ultimately shoot back up.
This may sound complicated. And, Lord, it is complicated. But it's just a fancier version of "what goes up, must come down"--which nobody I know would dispute--or that overvalued markets will someday be properly valued or undervalued.
The meanest of those mean numbers above comes from Andrew Smithers, the London-based fund adviser and co-author of "Valuing Wall Street: Protecting Wealth in Turbulent Markets."
Smithers and his co-author, Stephen Wright of Cambridge University, calculate that the U.S. market as a whole is still vastly overvalued and must ultimately fall by about 50 percent to approach the actual value of U.S. companies.
Their methodology is based on a variation of Tobin's Q, a ratio devised by Nobel laureate economist James Tobin. Briefly and inadequately stated, Q is arrived at by dividing the market value of companies (their stock prices multiplied by the number of shares outstanding) by their replacement costs (what it would take to re-create their assets) as calculated by the Federal Reserve.
As Q moves above 1, stocks get progressively more expensive in relation to the companies.
More important, as Smithers and Wright explain, Q historically reverts to 1 or close to it, so that if Q is now in the neighborhood of 2, it's headed for a halving, as Smithers forecast in an interview with me last week.
Please spare me too many e-mails. Read the book (McGraw-Hill, 2000). I don't pretend expertise on Tobin's Q.
But Smithers and Wright claim to prove Q's validity historically in their book and to also show that it's a better gauge--at least in hindsight--than competing theories or measures of market value based on earnings, which can be and are manipulated.
Numerous scholars, and a lot of market professionals, challenge Tobin's Q, especially in view of the intangible nature of today's corporate assets. But plenty of academics also take it quite seriously.
And, as it happens, the Smithers-Wright forecasts are not that far from forecasts developed using wholly different methods.
For example, the worst-case scenarios of the number crunchers at Salomon Smith Barney Research suggest that if the Nasdaq reverted to its 28-year mean--a 13.61 percent annualized gain--it would hit about 1600 by the end of this year, according to that firm's calculations.
That's down about 40 percent from Friday's close and about 68 percent below the Nasdaq's high in March.
Similarly, the Dow would be cut almost in half, too, if it reverted to its 103-year mean, say the Salomon Smith Barney analysts, just as Smithers and Wright forecast using an entirely different approach.
Salomon Smith Barney's possibilities offer kinder, gentler scenarios as well.
Rather than plummeting by half, the Nasdaq composite could revert simply by gaining nothing until March 2008.
And if the Dow reverted to a 20-year norm instead of a 103-year norm, it would bottom out at about 8400, rather than 5300--or, in the alternative, go nowhere until May 2003.
What are investors supposed to do about all this?
As always, your answers must be adjusted for your own situations. Smithers and Wright reject the buy-and-hold approach as irrational, except for people who expect to live forever. They believe investors can minimize losses by getting out of stocks when the markets are overvalued.
On the other hand, many investors, professional and amateur, believe that trying to time the market's highs and lows is a fool's game and anyone who plays it is destined to end up poorer.
In all cases, you should be well diversified, invested not just in stocks but also in other assets. At a time of great uncertainty, as this is, it is doubly important to be prepared for anything. We are in a bear market.
Make no mistake about that, writes Salomon's Jonathan Lin, especially with regard to the Nasdaq and technology stocks. "If the definition of such an event is a decline of 20 percent plus from a closing high, what should we call a 40 percent plus decline?"
This is "more severe than just a short-term hit," he says.
As for the Dow, Lin writes: "We have some even more chilling thoughts for investors to ponder. Consider the fact that, by definition, a data series spends as much time below its average as it does above it.
". . . There is the possibility that the Dow might not only revert to the mean, but overshoot it by some margin in the process. This is the reality of the conclusion that one would draw by studying the very long-term progression of the market.
"Speaking of reality," he writes, "a popular phrase comes to mind: 'Reality bites.' "
A Dissent From time to time I publish responses from readers who take issue with my columns--with their permission. From Thomas Martin comes the following concerns about my column last week on mutual funds' capital gains distributions:
"I disagree with your outlook on capital gains in your column of Nov. 26. In particular, you refer to the investor as a 'victim' if he has to pay taxes on capital gains from end-of-year activity in a fund.
"Your individual who pays $5,100 in taxes on a $25,500 capital gain is a 'successful investor.'
"In your 10th paragraph, you say, 'When you get a capital gains distribution from a fund, it's generally reinvested in the fund. So you get more shares but no money.' You write as though the investor is simply stuck at the receiving end of this transaction. In reality, you should have said, 'The capital gains distribution represents a sale of the fund's assets. You can keep the proceeds of this sale or you can reinvest them. Either way, you will owe taxes on the sale. If you choose to reinvest your proceeds of this sale, you will need to have ready cash or other liquid assets to cover the tax bill.'
"The fund managers will follow the instructions of the investor, or they can expect a lawsuit. Your column overlooks the choices that could have placed the investor's money in his own bank account instead of back in the fund. Your advice on tax-efficient funds is useful, but I don't think it will help an investor who thinks he's just a victim.
"My fund is going to have a large capital gain this year. By selling off portions that no longer meet the fund's long-term objectives, the managers are doing exactly what I am paying them to do. My role is to pay attention and make the right choices for my overall financial situation."
Fred Barbash can be contacted at barbashf@washpost.com
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