WSJ article on "Cure to the Stock Malaise"
July 17, 2002
Market Medicine: Investors Look For a Cure to the Stock Malaise
By E.S. BROWNING and GREGORY ZUCKERMAN
Staff Reporters of THE WALL STREET JOURNAL
What will it take to get stocks moving up again? Surprisingly, the solutions
seem a lot clearer than they did just a few weeks ago.
Then, many investors saw the stock market as a conundrum: Economic
forces such as industrial production and consumer spending were strong
and money was flowing into mutual funds. Normally, trends like that would
be sending the stock market ahead, and yet stocks couldn't seem to get
going.
Now, as stocks have stumbled into one of their worst slumps in 30 years,
investors are coming to believe they are dealing with something more than a
garden-variety decline. It now seems possible that the bursting of the
late-1990s stock bubble has created a set of persistent market forces that
will need to be dealt with and resolved before stocks can truly recover.
Over the past two weeks, the
Dow Jones Industrial Average
has fallen more than 900
points, nearly 10%, including
a 166.08-point decline
Tuesday. The power of the
selloff has, for many, helped
clarify how deep the market's
problems are. That,
unfortunately, is the good
news.
The bad news could be that the fix won't be quick. Of the major factors
shaping the market now, two of the most important -- disagreement about
how much stocks are really worth and a lack of trust in corporate numbers
-- could take months, or perhaps longer, to overcome.
In addition, fundamental shifts such as less U.S. stock investing by
foreigners and a surge in trigger-happy hedge funds have fed the decline,
and could make climbing out of it that much tougher. All of this helps
explain why the markets, which only a few months ago were rebounding,
have faced such carnage. The Dow industrials are down some 20% over
the past four months.
All this gloom could be overdone. The stock slaughter of recent weeks
could mark the building of a so-called bottom, setting up the market for a
steady rebound.
But a look at similar periods in the past suggests the rebound could take
longer than the optimists hope. "This is the down-leg of a great bubble,"
says Ben Inker, the bearish director of asset allocation at Boston
money-management firm Grantham, Mayo, Van Otterloo & Co. "History
always has said that the great bear markets take their time."
Rethinking Trust in the System
Three decades ago, investor Ron Bunten started working with a broker to
pick stocks he thought would beat the market. Over the years, many did,
especially in the boom years of the late 1990s.
Then came a telecom crash and a raft of corporate scandals that
have helped to wipe out the most speculative part of his
portfolio, which included Global Crossing and WorldCom.
"They've all pretty much gone down the tube," says Dr. Bunten,
66, who retired this year as an orthopedic surgeon in Des
Moines, Iowa.
His faith in investing is gone, too. Today, Dr. Bunten is out of
the stock-picking game. He uses a conservative local investment
firm to put his savings in a mix of bonds and stocks that simply
track broad markets around the world.
No factor is more powerful in today's market than the crisis of
confidence. Analysts say questions of trust not only have
undercut investors' willingness to step in and buy stocks that
look cheap, but also have sown skepticism about whether
companies that seem to be on the mend can really be believed.
It reminds Steve Leuthold, chairman of Minneapolis
money-management firm Leuthold Weeden Research, of the
1970s, the last time stocks went into a prolonged bear market.
"You wiped out a whole generation of equity investors there that
never came back," he says.
Then, Mr. Leuthold was managing a mutual fund whose stocks
were going up. But when he would show up for work, he
would find that investors were pulling out anyway, moving to
the safety of money-market funds.
Whether things get that bad remains to be seen. They may not,
in part because investors have few other places to turn. Foreign
stocks are weak and money-market funds offer puny returns.
But even professional investors are gun-shy. In a survey by
Thomson Financial, the great majority said they now look for
accounting red flags before they will buy a stock. Asked about
market prospects, some said the basic requirements for a
recovery now are simply time and patience. Said one: "It will
take several more years to work off the 1999-2000 valuation
excesses, especially in tech."
Wondering What Stocks Are Worth
Most investors have accepted the painful truth that the most
popular stocks of the 1990s weren't worth what people thought
they were. That doesn't offer much consolation to investors today, who are more confused than ever about
what stocks are really worth.
Uncertainty about how to value a stock, post-bubble, is at the heart of why people are having a hard time
committing new money. Mr. Inker at Grantham Mayo figures companies in the Standard & Poor's 500-stock
index still are too expensive and the index could fall an a further 20%. But veteran UBS Warburg investment
strategist Edward Kerschner believes stocks are dramatically undervalued. He sees the possibility of a 20% rise
in the S&P 500 once investors see some positive corporate earnings news this year.
On paper, none of this should be so difficult to figure out. In the simplest sense, stock prices are a multiple of
expected earnings per share. If a company is expected to earn $1 a share next year, and if investors typically
have been willing to pay 20 times earnings for its stock, the shares should trade at $20. If the price gets well
above that, it may be too high, and if it's lower, there may be room to rise.
But investors disagree sharply now about some of the most basic elements of this simple calculation. For one:
How much are stock buyers willing to pay for earnings in this new environment? The bulls think they'll
continue to pay more than 20 times earnings for the stocks in the S&P 500, which currently trade at about 21
times. Skeptics think investors may be willing to pay only 17 times earnings, or less.
There also is debate about how much companies are capable of earning. Chuck Hill, director of research at
Thomson Financial/First Call, has been warning that Wall Street's earnings forecasts for the rest of this year
are far too bullish.
As the wave of scandals has deepened, there's even controversy over what goes into earnings -- what to
include or exclude in the calculation. Standard & Poor's itself this year decided to change the way it calculates
earnings.
All this assumes investors are prepared to heed earnings reports at all. Says Mr. Kerschner: "People don't
believe an analyst when he tells them earnings are going to recover, they don't believe the chief executive when
he tells them the earnings have recovered, and they don't believe the accountant when he confirms it."
Structural Shifts
Not all of the forces shaping stocks are external; some reflect shifts in the internal workings of the markets.
Among the most notable: an explosion in hedge funds.
These private investment pools control $560 billion in assets, almost double the amount two years ago. And in
a down market, many shift heavily from buying stocks to "shorting" them -- selling borrowed shares in hopes
of replacing them when they're cheaper. As the market has slid, money has poured into these funds from
institutions and wealthy individuals looking for a haven. Sensing that stocks still have room to fall, hedge funds
have stepped up their selling, putting serious pressure on the entire market.
"A lot of people are shorting, whether they believe in it or not," says Neil Weisman, general partner at one
hedge fund, Chilmark 21st Century Capital in New York. "Just like they played the momentum on the way up,
hedge funds are doing it on the way down."
The good news is that at some point, hedge-fund managers have to buy shares to replace the borrowed ones
they sold. Traders say "short-covering" is partly behind wild trading days such as Monday.
The hedge funds' actions, in turn, affect those of mutual fund managers. These managers feel pressure to beat
or at least match major indexes. In the late 1990s, this forced many to buy big stocks that dominated those
indexes, such as General Electric Co. and Cisco Systems Inc. But as the market has fallen, some managers
have dumped these same stocks to try to keep from falling behind the indexes. Some have shifted into other
market segments, such as small stocks, that have done better. All this has created something of a herd effect,
with few investors willing to stand in the way of a sliding market to buy big stocks even if they look cheap.
"The absence of that buying," says Kevin Johnson, research director at Philadelphia money managers Aronson
& Partners, "throws kerosene on the fire and causes lots of volatility."
Meanwhile, institutional investors have become more short-term-oriented. They feel pressure to sell stocks as
the market falters rather than hold on for the long haul, says James Paulsen, chief investment officer at Wells
Fargo Capital Management. He thinks this adds to the volatility, though it eventually could turn around and help
the market rebound.
As index investing and hedge funds have soared to prominence in the U.S., a shift in foreign money has also
changed the shape of U.S. stocks. Realizing in the 1990s that returns in the U.S. outstripped those at home,
foreigners surged into U.S. stocks. Their purchases in 2000 almost equaled those of U.S. mutual funds.
Now the money's going the other direction. According to the most recent data, foreign investors put $26
billion in new money into U.S. stocks in the first four months of this year, down from $47 billion in the like
period a year ago. Most analysts say the buying has slowed even more dramatically in the past month and has
likely turned to outright selling by many big foreign investors.
If the dollar stops plummeting, these investors may come back. But because the outlook for U.S. corporate
profits is no better than the foreign profit outlook, their buying may be meek.
"Foreign investors, especially European, are even more skeptical of the U.S. stock market and U.S. economy"
than U.S. investors, says Nicholas Sargen, chief investment strategist at J.P. Morgan Private Bank. "The most
likely scenario is subdued foreign buying of the U.S. market for some time."
401(k) Money: Braking the Fall
There is at least one bit of good news: For all the things pushing down on stocks, there's one important change
that's helping cushion the decline: an unceasing stream of investments into stock mutual funds through 401(k)
plans.
The 35 million people who participate in these retirement plans continue to use chunks of their paychecks for
regular contributions to stock mutual funds, even in the midst of the carnage. More than 65% of the new
money goes into stocks. "People listened to all the education in the last few years," says David Wray, president
of the Profit Sharing/401 Council of America, a trade group. "Younger people put 90% of their new money
into stocks."
Inertia is working in the market's favor. Most investors rarely change the allocation determining where their
money goes. Hewitt Associates, which administers $75 billion of 401(k) plans for almost four million
employees, says even during some of the recent painful days, well under 1% of its 401(k) money has moved
out of stocks. In total, more than $1.7 trillion is piled up in these retirement plans.
Thomas Petrarca, a 45-year-old who has lost more than $150,000, or 15%, of his portfolio this year, says he's
still putting the majority of his monthly 401(k) contribution into stocks. "I haven't bailed out. I think we're
close to a bottom," he says. "I'm investing for the next 10 to 15 years."
Still, there are some troubling signs for the market. Figures compiled by Hewitt show 401(k) investors now
are putting 30.3% of their new contributions in fixed-income investments, which is up from 27.2% in January.
During 17 of 20 trading days in June, more people moved money out of stocks to bonds than moved money
from bonds to stocks.
Concern about more such withdrawals leads mutual-fund managers to sell some stocks to raise cash to pay
off investors who want out. Traders say that helps explain why some solid stocks that had been doing well,
such as defense and homebuilding shares, now are falling.
Some skeptics, such as Thomas McManus, market strategist at Banc of America Securities, point to the
growing disenchantment with stocks as a paradoxically upbeat sign. Individual and foreign investors have a
poor track record, often leaving the market just as things hit bottom, such as in October 1998. If they're
souring on stocks now, it could be a sign that the most entrenched optimists are throwing in the towel,
suggesting that there won't be terribly much more selling left.
But it's also true that disgust with stocks by such investors helped hold the market back from 1966 to 1982.
Since individual and foreign investors play a bigger role in the markets today, if they lose faith, stocks could
suffer for years, some say.
"We would have fallen more quickly without this continuous flow of investment," says John Vail of Mizuho
Securities USA in Chicago. "If 401(k) investors and those with automatic investment plans shift out of
equities, it would be very damaging to the market."
The Lessons of History
Every stock bubble is different. Some pop with a bang; others deflate slowly. But one thing seems to be true
for all of them: Repairing the damage takes time.
After the 1929 crash, it took the Dow Industrials about three years to bottom out, in 1932. Then it took 22
additional years to get back to the 1929 high, which finally happened in 1954.
When the "Nifty Fifty" bubble popped in 1973, the Industrials fell 45% in just under two years, and then took
eight more years to return to their high.
The Japanese bear market that began at the very end of the 1980s took more than a decade to bottom out --
assuming it has done so. Just as markets tend to go to extremes during booms, they tend to overshoot on the
way down afterward.
This latest bubble in U.S. stocks was centered most heavily on the Nasdaq technology stocks, whose rout has
been thorough. The Nasdaq composite is 73% off its record of 5048.62 on March 10, 2000. The Dow
Industrials are a far smaller 28% below their peak, also hit in 2000. The S&P 500 is 41% off its high.
So the Nasdaq drop is the big one. The Dow and S&P aren't down as much as in other recent bear markets.
The S&P 500 was off 48% in 1973-1974. The Dow Industrials fell 36% in 1987.
Why the variation? Not all stocks are suffering. Those with dividends, those whose prices are low relative to
their earnings and those related to real estate and construction have held up better than most. The real pain, and
the real skepticism about the future, lies with the Nasdaq technology stocks. Few people expect any of the
indexes to return to their old highs soon.
"I may not even see us break 5000 in the Nasdaq again, and I intend to live to 95," says Mr. Leuthold. He is 64
now.
Write to E.S. Browning at jim.browning@wsj.com and Gregory Zuckerman at gregory.zuckerman@wsj.com
Updated July 17, 2002 2:38 p.m. EDT
Copyright © 2002 Dow Jones & Company, Inc. All Rights Reserved |
