Barron'sGone to Extremes
Gone to Extremes - Jonathan R. Laing
After a gut-wrenching quarter, we examine two charts comparing stock prices and bond yields that suggest the damage is
overdone. Getting ready to rally?
April 2, 2001
Barron's Features
Are We There Yet?
Low bond yields and plunges in stock prices suggest the market's near a bottom
By JONATHAN R. LAING
The stock market proved yet again to be the street of broken dreams last week. Though a modicum of equanimity appeared
to be restored by Friday, that only came after a gut-wrenching plunge Wednesday that wiped out many of the gains that the
market had managed to string together in the three preceding sessions. The week thus closed out one of the grimmest
quarters in stock-market history, with the Dow down around 8%, the Standard & Poor's 500 index off 12% and the Nasdaq
more than 25% lower.
Obviously the question on all investors' minds is: When will the pain end? At least riders on a roller coaster, shrieking as it
barrels down a big incline, have the comfort of seeing the bottom of the dip and the rise ahead of it. Stock investors have no
such luxury.
There's little for investors to hang on to these days. The fundamentalist fraternity offers little succor. Stocks never seem to
be cheap enough for them to buy without reservation. And the technicians? They're just as clueless. The only change these
days is that they are reading the entrails of eviscerated investors rather than those of chickens.
And we admit some befuddlement ourselves. But we chanced upon a couple of charts put together by two of Wall Street's
canniest market observers -- Morgan Stanley Dean Witter's Byron Wien and Ed Hyman of ISI Group -- who appear to offer
some solace to worried stock investors, if not financial recompense for past losses.
interactive.wsj.com
Top chart: When stock prices and bond yields fall, the market usually is due for a rebound. Bottom chart: Those severe
drops in stock prices and bond yields have rendered equities undervalued by this measure.
Both charts seem to indicate that the bottom in the stock market is nigh, if past market behavior offers any guide. That said,
we should hasten to add that markets at times have a tendency to do the unprecedented. And one must remember that hoary
market saw about charts -- namely that almost every ship at the bottom of the ocean had a chart room.
Wien's stock-market valuation chart is of special interest because of its battle-tested past and rigorously conservative
assumptions. The model seeks to determine an equilibrium level at any point in time where stocks (the S&P 500) and bonds
(now the benchmark 10-year U.S. Treasury) are equally valued by a rational investor after weighing the different risk
profiles of the two investment alternatives.
Wien's model currently places the fair value of the S&P at 1326 -- some 14% higher than Friday's close of 1160.34 -- using
a dividend-discount model that assumes a 10-year earnings growth rate for the index of 9.8%, slower growth thereafter, a
4% increase in operating earnings for the S&P this year to $57 a share and a bond yield of 4.96%.
In addition, Wien bakes an equity-risk premium of 2% into stocks, on the theory that fair values for stocks should be clipped
some in relation to government bonds because of stocks' greater uncertainty of return.
During the heyday of the late-'Nineties New-Era bull market, some observers argued that stocks required no risk premium.
After all, don't stocks always outperform bonds nearly every historical period of more than five years in duration? Besides,
stocks' greater risk is more than compensated for by their participation in the future profit growth of their underlying
enterprises as opposed to just the fixed returns of bonds. And, finally, the seeming taming of the business cycle in the
'Nineties appears to make stocks safer. Events these days, however, seem to be proving most of these notions laughable.
The Wien chart of stock market over- and undervaluation going back to 1980 resembles the EKG of a chihuahua on
amphetamines in its extremes. In September of 1987, just before the 1987 Crash, the model soared to an overvaluation level
of nearly 40% before collapsing to an undervaluation reading of 17.5% just two months later.
And in December 1999, just a month before the S&P's all-time peak, and three months before the Nasdaq Crash began,
stocks moved to a record high of 55% overvalued. It was at precisely this point that even Wein's colleagues openly joked
about the irrelevance of Wien and his goofy model. Perhaps the times had passed the 60-something market strategist by.
But these days the S&P has moved into deep undervalued territory. This reflects both the precipitous slide in stocks and
bond rates since the beginning of the year. So, are we nearing an important stock market bottom?
Probably, Wien said in a telephone interview with Barron's between ski races in a Pro-Am event. In the past, stocks have
tended to make a final low at undervaluation levels of between 10% and 20%. That was the case in 1987, 1994 and 1995.
Only in 1980 did the model's stock undervaluation level reach lower levels, hitting 30.9% in June of that year.
Still, Wien offers some cautionary statements to temper the bullish implications of his model. He warns that the stock
market became so grossly overvalued in 1999 and early 2000 that the danger of a symmetrical move to the downside may
exist this time around. "I'm also worried that we haven't seen unambiguous signs of capitulation, with mutual funds dumping
blocks of stock to meet heavy investor redemptions," he averred. "But I do think it's too late for investors to sell, but not too
early for them to buy stocks."
Later that day, Wien called back to slightly amend his statement. "Just say that it's not too early for investors to buy some
stock," he elaborated.
The second chart, from Ed Hyman's ISI Group, illustrates the yin and yang relationship between stock and bond market
performance. Under ordinary circumstances, a sharp rally in bonds -- i.e., a precipitous slide in bond yields -- is good for
stock prices.
After all, plummeting yields tend to make stocks more attractive to investors looking for enhanced returns. And the Treasury
market arguably already has reflected all the rate-cutting the Federal Reserve is apt to do with the 10-year note below 5%,
where Greenspan & Co. still is pegging the overnight federal funds rate, making fixed-income investments relatively less
attractive. Lower interest rates also bolster economic activity by reducing borrowing costs for businesses and consumers
alike, and by fattening profit margins.
But most interesting are periods in which the performance of these two key markets wildly diverges. The past six months
has witnessed such a period. The chart attempts to capture this phenomenon by adding together the year-over-year
percentage change in the price performance of the S&P and the year-over-year percentage change in the 10-year Treasury
yield.
The latest reading, a negative 46.3%, shows the largest divergence in the two markets in some 40 years of data. That outlier
negative reading was the result of a big bond-market rally than sent yields tumbling, and the sharp decline in the S&P.
interactive.wsj.com
The chart imparts several messages. First, such gross divergence between a falling stock market and soaring bond market
tends to signal periods of extreme stress in the economy. Notice the four previous lows on the chart during the 1974 and
1982 recessions, the 1987 stock market crash and the 1998 Russian ruble- and Long-Term Capital panic.
But of more relevance to investors, invariably stocks markedly outperform bonds in the year after periods of major
divergence like the current one. Add to this the fact that stocks have posted back-to-back years of negative total returns only
once since 1920 (that was in 1973-1974 during an inflationary recession, the worst of all economic worlds), and investors
ought to feel pretty good about the stock market's prospects in the months ahead.
For last year was a year of negative returns for almost all of the stock market's major measures. And the past lows in the ISI
divergence chart -- 1974, 1982, 1987 and 1998 -- turned out to be sensational buy points for the stock market.
Going to Extremes
Yet Karina Mayer, a managing director of ISI, offers several caveats about the chart. She stresses that no one knows how
long the current period of market divergence will last or how extreme it could become. The drop in the current reading has
already fallen into record territory and threatens to fall right off the chart as currently calibrated.
Mayer theorizes that the current stock-market downturn may prove to be more prolonged and intractable than most other
post-World War II bear markets. For this downcycle is being driven by a glut of productive capacity and resulting steep
decline in capital spending rather than the typical inventory excesses of past contractions. It's far quicker and easier to work
off inventory gluts than excess capacity.
Likewise, she and ISI worry that this bear market could have a far more corrosive impact on consumer confidence than past
bear markets. Household ownership of stocks is so much greater today than ever before. "We here at ISI definitely believe
in the wealth effect and the fact that stock market losses could have a major effect on U.S. consumption," she observes.
Of course, one must remember that falling interest rates don't always revivify stock prices or even economies, for that
matter. The Japanese economy and stock market, after all, have been in an 11-year funk, despite interest rates that have at
times dropped to zero percent or just above.
Not to worry, says Mayer. Japan's problems have arisen, in part, from its citizens' unwillingness to consume. That has never
been a problem with the American consumer.
Let's hope so. For the sake of the stock market if nothing else.
--------------------------------------------------------------------------------
URL for this Article:
interactive.wsj.com
-------------------------------------------------------------------------------- |
