It Was a Party So Wild, The Cleanup Goes On
By E.S. BROWNING
Staff Reporter of THE WALL STREET JOURNAL
Wall Street has its eyes riveted on Iraq right now, hoping that a swift war will put an end to a bear market that began three years ago next week.
But Wall Street may be looking in the wrong place.
There's no doubt that worries about war and terrorism are holding stocks back at the moment. Trading volumes are tepid and many investors are reluctant to buy stocks in advance of a conflict.
But in the longer term, something much more fundamental is going on in the market: Many stocks still haven't finished working their way through the aftereffects of one of the greatest bubbles in investment history.
That bubble popped nearly three years ago, on March 10, 2000 -- though investors didn't know it at the time -- when the Nasdaq Composite Index hit a record that turned out to be its peak. Then began what would eventually become a 78% decline. (The Dow Jones Industrial Average peaked in January of the same year and other major indexes did so in early 2000 as well.)
If history is any guide, it will take more than the nearly three years that have passed to move beyond the aftershocks.
After past bubbles, stocks stayed soft for years, leading experts to think that investors should spend at least as much time studying the history of stock bubbles as they do worrying about military operations in Iraq.
"Iraq is a huge short-term behavioral issue. It matters to the market because it matters to people. But in terms of longer-term fundamentals that determine real value, it is largely irrelevant," says Jeremy Grantham, co-founder of Boston money-management firm Grantham, Mayo, Van Otterloo. Mr. Grantham was one of the few investment pros to warn during the 1990s that an enormous bear market was looming.
"In terms of the long term, what the market is worth and where it will end up aren't about Iraq and aren't about terrorism. It is about long-term bubbles and long-term spending cycles and long-term optimism giving way to long-term pessimism," Mr. Grantham says.
On that score, according to investors and others who have studied past bubbles, the prognosis isn't cheerful. Sure, the stock market is likely to bounce back sharply if war in Iraq is a quick success, or is somehow avoided. But even then, these people say, investors may well revert to their bear-market behavior.
"The bubble that we have just experienced is just such a major historical event, that had such profound effects on our thinking, that there hasn't been time enough yet for people to change their patterns of thought thoroughly," says Yale economics professor Robert Shiller, whose book "Irrational Exuberance," published in 2000, warned of the bear market.
Many investors still expect too much from stocks, Mr. Shiller explains. That leaves them open to more disappointment, and that, in turn, could drive stocks down again before a real recovery begins. The bull-market notion that stocks and the economy had entered a new era "had a powerful psychological impact on us, just as fairy tales do on children who believe in them," he says.
That doesn't necessarily mean that stocks will fall sharply again. Even Mr. Grantham, who remains bearish, thinks most of the decline is behind us. But that also doesn't mean that a lasting market boom awaits.
Mr. Grantham's study of bubbles suggests that it takes them about as long to deflate as it did to inflate. If the latest bubble started to inflate in 1996, he says, then it could be the second half of this year before the market has returned to fair value. The problem, he adds, is that markets rarely stop declining when they hit fair value. They generally overshoot, and he thinks it could be years before the process runs its full course. He says the Standard & Poor's 500-stock index could fall more than an additional 20% from its current level.
Most investors are less pessimistic, of course, but many agree that the coming years could be characterized by difficult ups and downs. Consider past experience.
The period of repeated bear markets that followed the 1929 crash, for example, lasted until 1942, when success at the Battle of Midway helped spark a turnaround, according to market-research group Ned Davis Research in Venice, Fla. The ensuing bull-market period lasted until 1966, and was followed by another long bearish period that didn't end until 1982. That produced the great bull market that finally collapsed in 2000. Given that history, it would be an anomaly if the current bearish period were to end after just three years.
"We debate this issue a lot around here, but I think the best comparison for the current period is to the late 1970s," says Tim Hayes, global stock strategist at Ned Davis Research. If he is right, it means that investors could face at least a few more frustrating years of volatility. The bearish period that dominated the 1970s included some big rallies, such as a 76% surge in the Dow Jones industrials from late 1974 through September 1976. But stocks repeatedly stumbled.
The troubles actually began in 1966, when the Dow Jones industrials hit 995 and then ran out of steam. They broke 1000 briefly in 1973, only to fall again. Another brief surge above 1000 ended in 1976, and another in 1981. The industrials didn't move above 1000 for good until 1982, after moving sideways for 16 years.
Stocks have begun doing something similar in the years since their 2000 peak, although the trend so far has been down, not sideways. Nasdaq stocks in particular, which were the ones most affected by the bubble, have seen repeated double-digit rallies, only to top out and give back all or most of their gains.
The most recent low for the stock indexes occurred this past October, and whether it proves a lasting low, or just an interim one, remains to be seen. The low for the 1970s occurred in 1974, but even then, it was eight more years before the market stopped floundering.
Not everyone is that gloomy. The 1930s and the 1970s were characterized by economic troubles much more severe than anything seen recently. The main trouble today appears to be war and terrorism. Many money managers are hoping that, if the war and terrorism worries can somehow be overcome, stocks could put in strong gains. But even some bulls remain cautious.
Finance professor Jeremy Siegel of the University of Pennsylvania's Wharton School, whose book "Stocks for the Long Run" often has been cited as a justification for rapid run-ups, acknowledges that stocks today aren't exactly inexpensive. He just believes -- unlike Mr. Grantham -- that they no longer are overpriced.
"I don't think stocks are dirt cheap, and in bear markets they can go to an undervalued range -- and that is what some of my bearish friends say," Mr. Siegel notes. "I say that may be true, but if stocks are in a normal range now they are a sound long-term investment."
The only way stocks could be a bad long-term investment would be if the U.S. entered a Japan-type deflation period, Mr. Siegel says. He thinks that will be prevented by the Federal Reserve.
Ray Dalio, president of money-management firm Bridgewater Associates in Westport, Conn., which manages $38 billion, long was bearish on U.S. stocks, but has turned more bullish in hopes of at least a short-term rally. He, too, however, warns that stock gains over a longer term could be subpar.
If the economy begins to perform normally, stocks could achieve average gains of 6.5% a year, according to Mr. Dalio's calculations. That is below the long-term average gain of the past, which is in the low double digits, and it is far from the 20% a year that major indexes posted in the late 1990s.
The problem, Mr. Dalio says, is that during the bubble, stocks were priced as if companies in the S&P 500 could earn a net of 9% a year after inflation. "That was ridiculous," he says, since companies have averaged after-inflation profit gains closer to 2% in the past.
Now, after all the declines, stocks finally are back to a level that assumes a 2% annual profit gain, and that has made Mr. Dalio more bullish.
"Stocks have gone from being ridiculous to being reasonable," he says. "That doesn't mean they are cheap."
When stocks have been truly cheap and ready for big gains in the past, he says, they have tended to be priced as if companies were going to lose 3% a year. They aren't there, at least not yet. "Most of the bubble has come out" of stock prices, says Mr. Dalio, but that doesn't mean a roaring bull market is ahead.
Friday's Market Activity
Despite a small gain Friday, the Dow Jones Industrial Average made February its third down month in a row.
Friday's gain of 6.09 points, or 0.08%, to 7891.08 left the industrials down 127.03 points, or 1.6%, on the week, breaking a string of two weekly gains. It was down 2% for February and has declined 5.4% since the year began.
AOL Time Warner finished the session up 58 cents, or 5.4%, at $11.32 after the company's America Online unit named Stephen M. Swad executive vice president and chief financial officer.
Ahold continued to weigh on supermarket stocks, falling 40 cents, or 9.8%, to 3.70. The Dutch supermarket chain announced Monday it overstated earnings due to accounting irregularities.
Gap tumbled 1.78, or 12%, to 13.04 after the retailer reported earnings in line with expectations, but warned that February sales may miss projections because of drops in consumer confidence and bad weather. Banc of America and Lazard cut their ratings on the retailer.
Dana Corp. fell 59 cents, or 6.4%, to 8.56 after J.P. Morgan said the auto-parts firm is among the most vulnerable to second-quarter auto production cuts. Delphi Corp. shed 27 cents, or 3.4%, to 7.73 and Gentex (Nasdaq) fell 24 cents, or 0.9%, to 26.88.
Jabil Circuit (Nasdaq) rose 91 cents, or 5.8%, to 16.61 after Japan's NEC Corp. agreed to sell a broadcast equipment-making unit to Jabil for an undisclosed sum, while providing an NEC unit with full manufacturing and system-assembly productions services.
-- Shaheen Pasha
Write to E.S. Browning at jim.browning@wsj.com2
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Updated March 3, 2003 1:07 a.m. EST
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