TCS Daily

What Goes Down...

By James K. Glassman - January 8, 2002 12:00 AM

During a particularly long drench, someone asked Mark Twain whether he thought it would ever stop raining. "Always has," he replied.

The same with the stock market. It rains, but the sun comes out again. Stocks fall, but they always recover to a higher level.

Still, it could keep raining for decades, and no one knows for certain what's ahead for the stock market in the next year. But we can make an educated guess, just like Mark Twain, by examining history. The past may be an imperfect guide to the future, but it provides the best source material we'll ever find.

For 2002, the relevant message from history is that it is extremely rare for stocks to perform poorly for long periods. And it's no secret that stocks have been lousy lately. All of the major market averages have dropped for each of the past two years. The Standard & Poor's 500-stock index, the benchmark used by most money managers, declined 9 percent in 2000 and 12 percent last year (all these figures account for dividends); the tech-heavy Nasdaq composite index fell 39 percent in 2000 and 21 percent in 2001; the Lipper international mutual fund index dropped 15 percent in 2000 and 20 percent in 2001; and the Dow Jones industrial average, which includes 30 large, stable companies, fell 5 percent in both 2000 and 2001.

It is reasonable to conclude that, if the market follows its established behavior, it should rise substantially in 2002.

I am not a believer in numerology, but the trend is powerful. Almost always, when the S&P falls during a calendar year, it bounces back the year after. From 1941 to 1999, the S&P fell in 12 years, and in 11 of those cases the S&P rose in the following year -- by an average of 24 percent.

The single exception to this rule (until last year, that is) occurred in 1973 and 1974, when the 500 large-company U.S. stocks that make up the S&P suffered back-to-back losses during a terrible time that featured a war in the Middle East, the resignation of a president, and an economy that suffered simultaneous recession and inflation. Stocks lost 37 percent of their value. But over the following two years they roared back with a vengeance, gaining 70 percent.

In other words, to believe that stocks will be rotten again in 2002 is to believe they will buck a strong tide that has been running in the same direction for more than 60 years. Go back further. After the Great Crash, stocks fell four straight years, 1929 to 1932, for a total loss of 64 percent. But that was a time of terrible economic mismanagement, trade wars and 25 percent unemployment. At any rate, over the following four years, stocks tripled in value, recouping the loss and then some. The S&P dropped in each of the three years leading up to World War II (1939-1941), but that decline was more modest -- 21 percent in all. Over the following four years, the S&P returned 146 percent.

Okay, enough numbers. The point is this: Like a buoyant lifesaver or a rubber duckie, the stock market usually doesn't stay under water very long. Forces that seem almost elemental push it back to the surface. Those forces are economic. In other words, the reason that stocks tend to bounce back is not because of the metaphysics of market cycles but because of the resilience of the U.S. economy.

Stock prices and economic growth are linked for a simple reason: A stock's price is determined by expectations of future profits, and, if the economy is bad, profits are bad.

Between World War II and the end of the millennium, the U.S. suffered nine recessions. (A recession is typically defined as occurring when output declines for two straight quarters.) The average recession lasted 11 months; the longest, 16 months. Often, booms create busts -- usually because investors, businesses and policymakers get sloppy in their euphoria and because the inflation that usually accompanies a boom prompts the Federal Reserve to crack down with higher interest rates. But busts also create booms -- as policymakers wise up, businesses pare back their excesses, investors send their capital to truly deserving ventures and interest rates fall.

You don't really need to know the precise reasons or the exact timing. Only know this: The U.S. economy bounces back. During the 1930s and the 1970s, the process took a particularly long time, moving in fits and starts, and if you think the current period bears a strong relationship to those eras, then you should be wary of stocks. You should also be wary if you think that vulnerability to a new kind of terrorism will scare consumers, add severe costs for businesses and governments, and spook investors.

I think that, while these concerns exist, they are outweighed by the economy's proven strength in past wars and crises -- though I understand that the very short term is utterly unpredictable, and stocks could fall before they rise again.

Few analysts believe the United States will relive the Depression, but they raise the 1970s -- specifically, the period from 1973 to 1979 -- as a warning to investors. If you had put $1,000 into the S&P 500 stocks on Jan. 1, 1973, you would have been left with just $691 in purchasing power by the end of the decade. A nightmare. But inflation rose at an annual rate of 9 percent during those years. Ask yourself whether the Fed will ever again allow it to get so far out of control.

Anyway, what was the alternative in the 1970s? An investment of $1,000 in Treasury bonds at the start of 1973 declined to $707 in purchasing power by the end of 1979. And while bonds did beat stocks by a little, how would you know that the end of the 1970s was a good time to switch back to stocks? During the following two years, stocks rose while bonds fell 20 percent.

The point is that there is no need to obsess over what the economy will do next. As long as you can ride out the storms, the stock market is always the best place for your long-term money. According to the Chicago research firm Ibbotson Associates, while the S&P declined in 22 of the 76 years between 1926 and 2001, it fell in only two of the 65 overlapping 10-year periods between those dates. And stocks beat bonds and Treasury bills in every one of the overlapping 20-year periods since 1926 (1926-1946, 1927-1947, etc.).

Don't bother trying to time the market, jumping in and out when you think it's about to turn up or down. Stocks tend to rise when investors least expect it. Who could have guessed that the Nasdaq index would soar by nearly one-half from its low just after Sept. 11 to the first few days of 2002? Or that the Dow would climb by nearly one-third?

In fact, the most troubling aspect of this economic downturn (and the bear market that began in the spring of 2000) is that so many analysts are convinced it's over. Optimism is a poor backdrop for a recovery. As James Grant wrote recently in his newsletter, "Almost nobody saw the recession coming, but multitudes believe they see it going."

Also bothersome are traditional indicators of valuation -- especially price-to-earnings (P/E) ratios, which tell investors how many dollars it takes to buy a dollar of a company's profits. At year-end, the P/E for the S&P 500 was a whopping 41 -- nearly three times the historic average. A few months ago, H. Bradlee Perry, a veteran analyst for David L. Babson & Co., in Cambridge, Mass., wrote to clients: "This bear market shows one dramatic difference from all of its predecessors since 1950: most high-quality stocks have not been driven down to anywhere near cheap valuation levels."

In 1974, for example, the S&P fell to a P/E of 6 (!) when it hit bottom; in 1982, to 7. Today's S&P is probably distorted by huge, one-time write-offs, but even after adjustments, it's almost certainly higher than 20.

So here's a paradox: The history of the market as a whole shows one thing (that stocks should rebound sharply) while the history of P/E ratios shows something else (that they haven't reached bottom yet).

History does not repeat itself in every detail. If it did, the United States would still be an English colony. Things change. From the early 1930s to the late 1950s, for example, it was an ironclad rule that stocks had to pay dividends that were higher than Treasury-bond interest rates. If stocks did not, then they were surely overpriced. But in 1958, stock prices surged 43 percent, and suddenly bonds were yielding more than stocks. Time to dump your shares? That would not have been wise. Over the next 10 years, the S&P rose 159 percent. And since 1958, stock dividends have never exceeded bond rates.

What's changed this time? Investors, it seems, have become more comfortable with risk and more oriented toward the long term. As a result, they seem to be willing to tolerate higher P/E ratios (and higher stock prices) because they understand that stocks are a better deal than bonds. (By the way, this is the idea that economist Kevin Hassett and I developed in our 1999 book, "Dow 36,000.")

You may disagree, believing with Perry that, even if the economy is on the verge of recovery, "the next big party for investors may be quite a ways off." Still, the way to assuage your worries about P/E ratios is not to eschew stocks entirely but to direct a larger part of your portfolio toward value -- cheaper, unwanted companies.

Robert C. Carlson, who chairs the Fairfax County Employees' Retirement System and edits the excellent Retirement Watch newsletter, recently told subscribers, "While I'm optimistic that the economy is nearing a bottom, I want to be cautious with our portfolios a little longer." He recommends "conservative value-stock funds" -- specifically, Dodge & Cox Stock, Longleaf Partners and Schroder U.S. Smaller Companies. Last year, the average growth-stock mutual fund fell 17 percent, but Carlson's three funds all rose: Dodge & Cox by 10 percent; Longleaf, 11 percent; and Schroder, 12 percent.

Will they keep rising? That's a question no one can answer. My guess is the market is poised to rise sharply this year, but hedging that bet with value stocks may be a prudent maneuver -- like keeping an umbrella with you just in case it keeps raining for a third year.

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