New Reasons to Wonder if the Worst Is Over
By TOM REDBURN
ECONOMIC VIEW
The New York Times
July 14, 2002
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.
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