TCS Daily


He Moves In Mysterious Ways

By James K. Glassman - May 28, 2002 12:00 AM

The Dow Jones industrial average is lower today than it was in mid-1998. The broader Standard & Poor's 500-stock index has lost a quarter of its value since the end of March 2000. As for the Nasdaq: Don't even ask.

What is puzzling is not that the market has been knocked for a loop. That's what normally happens when the economy slows. No, the mystery is that the market hasn't been able to get up off the mat. While the Dow bounced back dramatically from its collapse of more than 2,000 points right after the Sept. 11 attacks, it has since languished. Stocks are still lower today than they were in August, and the Dow is about 1,000 points below its high of a year ago. This is not the way a recovery usually works.

Technically, the bear market is over. It was the second-worst since World War II, with the S&P declining 37 percent from its March 24, 2000, peak to its Sept. 21, 2001, trough. The Nasdaq's slide -- 72 percent over roughly the same period -- was the deepest in its 30-year history. But the recession itself was shallow. Gross domestic product, which measures U.S. output, fell in only one quarter (July through September); since then, it's risen at a brisk pace -- better than a 3.5 percent annual rate. Typically, the market starts rising a little before the economy does, but this time it's still in the dumps.

Investors tend to anthropomorphize markets. For example, I asked at the start: What ails the market? In fact, markets aren't people. They don't get sick or depressed or hyperkinetic. A market is merely a place where buyers and sellers come together. The prices that come out of these transactions are the result of dozens -- maybe millions -- of separate factors. Attempting to pick out the most important is like trying to select the key thread in a tapestry. Still, the sluggishness of stocks is on every investor's mind, and it's worthwhile exploring the current environment for clues. Here are six possible explanations for the current sluggishness. I rate each as a "slug factor" for its current role in weighing down the market.

  • Terrorism overhang. Yes, stocks recovered sharply after Sept. 11, correcting what was an understandable overreaction. It was a terrifying time; no one knew what would happen next. Since November, however, the Dow has remained in a narrow, uninspiring range. Judging from such events as the sharp rise Wednesday on the rumor that Osama bin Laden had been captured, I think it's safe to say that terrorism continues to worry investors. And why not? Wise investing can be defined as the commitment of capital for the long term. If terrorism becomes severe, investors will wonder whether the long term will ever arrive.

    Terrorism is not affecting consumers so much as it is affecting investors. They haven't bailed out of the market (see below), but they haven't indulged in the kind of optimism that normally accompanies an economic turnaround. My guess is that, over time, terrorism will diminish as a market factor. With the passage of time, the United States will either suffer more attacks, and investors will learn that we can continue to thrive nonetheless, or we will suffer no attacks and the threat will pass from investors' consciousness. Obviously, there is a third alternative that is too horrible to consider. (Slug factor: 7 out of 10.)


  • Enron fallout. Politicians frequently refer to the decline in "investor confidence" that has followed the revelations that Enron Corp. executives had deceived the public. But evidence of that disaffection is hard to find. Over the past three months, net inflows into stock mutual funds (that is, new investments in those funds minus redemptions) have totaled $55 billion -- that's about twice as great as inflows during all of last year and a pace that would make 2002 the third-best year in history. Just from talking to investors and reading their e-mails, I know that they have found the Enron affair disillusioning, even heartbreaking, but few seem to have bailed out of the market because of it. Investors are scrutinizing companies more closely and viewing the recommendations of analysts more skeptically. Suspect stocks such as Tyco International and AES Corp. have tumbled. All that is good news, and while innocent stocks may have been battered as well, a post-Enron hysteria does not appear to have swept the market.

    In a recent issue of the Chartist, newsletter editor Dan Sullivan complained about "the dearth of outraged investors." Maybe they will become outraged and desert the stock market in the months ahead, but they haven't yet. (Slug factor: 4.)


  • Overvaluation. Some analysts think the reason stocks haven't recovered much is that there was nothing to recover from. For example, M. David Testa, chief investment officer for T. Rowe Price Associates, the Baltimore mutual fund house, notes, "The market never got nearly as cheap as it has even in an average market environment, much less a bear market." The rebound, he says, "took it to levels more characteristic of a mid- to late-stage bull market environment."

    During a recession, with profits abnormally low (or nonexistent), it is difficult to pinpoint valuation measures like the price-to-earnings ratio. The raw P/E currently for the S&P is an astronomical 45; the "normalized" P/E, after taking into account extraordinary write-offs, is probably between 25 and 30. That is about double the P/E average for a bear market. According to the Leuthold Group, P/Es for large-cap stocks are higher today than when Alan Greenspan, the Fed chairman, issued his famous warning about "irrational exuberance" on Dec. 5, 1996. The overvaluation camp argues that investors are worried that, with P/Es so lofty, stocks could still have further to fall -- so they aren't eager to bid up prices.

    My own view is that stocks are not overvalued. Yes, P/E ratios seem high when compared with history, but that may not be the right thing to compare them with. In "Dow 36,000," my co-author and I posed the theory that stocks, which have returned an annual average of more than 7 percent since 1926, compared with about 2 percent for bonds, were considerably undervalued and that P/E ratios would rise as investors continued to recognize the bargain that equities presented compared with debt: a vastly higher return with about equal long-run risk. Indeed, P/E ratios have risen since the book appeared in late 1999. But stock prices have fallen -- because "E," or earnings, have fallen, an issue I will get to below.

    Still, while valuation certainly counts, investors have lots of low-P/E stocks to choose from. Among the stocks that the Value Line Investment Survey ranks at least "2" (above average) for timeliness and at least "3" (average) for safety, here are some with P/Es below 12: Pulte Homes, home building; GreenPoint Financial, thrift; Nissan Motor, autos; Sears, Roebuck, retail; Sola International, medical supplies; Precision Castparts, aerospace; and American Axle, auto parts. Note that Value Line uses an unusual, but to my mind useful, method for calculating P/Es. It uses actual earnings for the past six months plus projected earnings for the next six. With this method, the average P/E is 21, or more than 15 percent higher than last year's market peak. (Slug factor: 3.)


  • The economy, stupid. The stock market is one of the government's official leading economic indicators, and it does tend to predict what will happen next. Perhaps the sluggishness of stocks simply anticipates a sluggish economy ahead.

    Certainly, the market has seemed to respond negatively to news like the recent rise in the unemployment rate and the decline last week in those aforementioned leading indicators. Maybe the recession isn't over, or perhaps we'll have a double dip. Perhaps. But while the economy is eminently unpredictable, there is little reason to believe it won't grow at a 3 percent rate or more this year. All five of the measures that the National Bureau of Economic Research uses to gauge recessions were far milder than normal this time around. The U.S. economy remains robust, and the world economy -- including, apparently, even Japan -- is recovering as well. (Slug factor: 4.)


  • The tech bubble. The collapse of high-tech stocks, many analysts believe, precipitated the general stock-market decline. The loss of wealth that the collapse entailed may even have touched off the recession. It's true the information technology sector of the S&P fell 74 percent during the bear market, and, excluding technology, T. Rowe Price calculates that the S&P itself would have dropped only by 15 percent. But, while a falling high-tech sector hurt the overall market and the economy, why should that decline continue to weigh on stocks in general? Shouldn't investors be more enthusiastic about a company like Sun Microsystems today, when it has a market capitalization of $24 billion, than two years ago, when it had a market cap of $200 billion? Sun is a company, don't forget, that earned an average of $1.2 billion annually between 1997 and 2001. Typically, when investors sour on a sector, they simply take their money and go to another sector. You can't blame tech for the sour market mood. (Slug factor: 2.)


  • Vanishing profits. While the 2001 recession was one of the mildest on record, the drop in corporate profits was one of the most severe. Earnings per share for the S&P 500, on an operating basis, fell 31 percent between 2000 and 2001; on an as-reported basis, they fell 50 percent. David Blitzer, chief investment strategist for Standard & Poor's, recently noted, "If one measures the change in earnings by comparing each quarter to the same quarter a year earlier, the last quarter of 2000 and all four quarters of 2001 are among the seven worst quarters in the last half century."

    Why? Blitzer offers the theory that low inflation, global competition and increased productivity add up to "less pricing power for corporations, combined with some upward pressure on costs" -- especially from energy. Very simply, corporations may not have the protections they used to have. For example, in the past, anyone who wanted to compete with the two dominant bookselling chains would have had to build or lease thousands of stores around the country. Instead, Amazon.com simply launched a Web site. The barriers to entry, thanks to the Internet and international trade, are lower. That's great for consumers and for the economy overall, but for individual firms it may mean shrinking profit growth and lower returns on invested capital. That, in turn, could mean lower stock prices.

    My colleague at the American Enterprise Institute, Kevin Hassett, offers another explanation for lower prices. In a recent article, he wrote: "Suppose that accounting firms have become permanently more conservative about what they are willing to label a profit because of the Enron crisis. Every possible expense that was buried in some footnote in the past has been pulled forward into today's earnings. If this is true, then there might be a few bad quarters while the adjustment occurred, but after that profit growth would return to normal."

    My guess is that the answer to the stagnant market lies somewhere in the profit story. Investors are concerned that growth rates will slow significantly. I am not convinced they are right -- in part because I have been reading Princeton economist William J. Baumol's important new book, "The Free-Market Innovation Machine," which argues that "innovation has replaced price as the name of the game" in major industries that are dominated by large companies. In other words, pricing power will not be eroded and profits competed away because firms with new inventions can score large profits from them. (Slug factor: 8.)


Remember, however, that markets move in mysterious, often perverse, ways. Perhaps, in the end, all this fretting about stagnant stocks may be a signal that prices in the near future won't be stagnant at all.

A version of this article first appeared in the Washington Post.
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