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Strategies & Market Trends : MDA - Market Direction Analysis -- Ignore unavailable to you. Want to Upgrade?

To: Tim Luke who wrote (8610)	3/21/1999 12:33:00 PM
From: umbro	Respond to of 99985

Joseph and the Amazing Technicolor Market By MARK HULBERT [source: nytimes.com] Deep within our psyches, many of us believe that good is inevitably followed by bad. Maybe we've been influenced by predictions like Joseph's in the Book of Genesis, that seven good years in Egypt would be followed by seven so severe that "the good years will be forgotten." With the Dow Jones industrial average's flirting with 10,000, it is a good time to re-examine this belief. What does history tell us to expect over the next, say, 10 years? Will they be bad years for the market, coming as they do on the heels of 10 fabulous years, when the market has gained 19.1 percent a year, on average? Or is that recent past meaningless? Though they may not realize it, many investors have already answered those questions. Indeed, they assume that the recent past is irrelevant. Many financial planners, as well as economists at life insurance companies and actuaries at retirement plans, project that stocks will produce gains at their long-term historical average -- between 10 percent and 11 percent a year -- despite last decade's outsized gains. Unfortunately, history suggests otherwise, according to the consensus of several finance professors I have consulted. When measured over a several-year horizon -- say, five to eight years -- returns on stocks tend to regress to the mean. That means that after several years in which stocks do better than their long-term average -- as they have in the 1990s -- there is a better-than-even chance that they'll underperform over the subsequent several years. But by how much will they underperform? Specific predictions are hard to come by, because the data are insufficient to make forecasts with much statistical confidence. But two economics professors, John Campbell of Harvard University and Robert Shiller of Yale University, have played out several "what-if" outlooks, all of which have profoundly bearish conclusions. The findings are even scarier in that they depend on just two seemingly innocuous assumptions. The first assumption: Stocks will someday trade at their historically average valuations. That means stocks will eventually trade at an average price-to-earnings ratio of 14, in contrast to 31 today. That is unobjectionable, given that stocks have always returned to their historical valuations, even if they take their time in doing so. The second assumption: Earnings per share at American companies will not grow appreciably faster than the economy. That also seems above reproach. Earnings per share may grow faster than the economy for a year or two, but it's hard to imagine that they can do so indefinitely. Granted these two assumptions, how bearish should we be? It depends on how long we assume it takes for stocks to return to their historical valuations. If it takes 10 years, the Standard & Poor's 500-stock index, inflation-adjusted terms, will end up 40 percent lower than it is today, according to the professors. And if it takes less than 10 years, the index will have to fall even further. Note that the two professors assume that P/E ratios will return only to their historical average -- around 14. They aren't assuming something far worse: the extremely low ratios seen at bear-market bottoms -- about 6, for example, in December 1974. Of course, it may take longer than a decade for stocks to return to their average valuations, but that is small consolation. Over the last 130 years, it has never taken more than 20 years for stocks to do so. According to the professors, even if it takes 20 years -- until 2019 -- the S&P 500, in inflation-adjusted terms, will nevertheless be 20 percent lower then than it is today. What has to happen for the professors to be wrong? Stocks must either remain at high P/E levels, or earnings per share must keep growing faster than the economy -- not just for a year or two, but for many years. Those are the twin hopes of investors who believe we've entered a new era, one in which anything is possible. Unfortunately, those believers include investors with a lot to lose: people who have but a few years until retirement, yet confidently keep their money in stocks. Mark Hulbert is editor of the Hulbert Financial Digest, a newsletter based in Alexandria, Va. His column on investment strategies appears every other week. E-mail: strategynytimes.com.