TCS Daily

Will It Stop Raining?

By James K. Glassman - July 2, 2002 12:00 AM

These are the times that try investors' souls.

But they are also the times that offer investors opportunities they may never see again. As Warren Buffett, the best investor of the 20th century, once put it, "Be fearful when others are greedy and greedy only when others are fearful." Fear now rules, so it may be time to get greedy.

A few weeks ago, I discussed half a dozen "slug factors" - reasons stocks have done so badly this year, including terrorist attacks and accounting scandals. Now, turn to the other side of the coin: "zip factors" - reasons to continue, or even accelerate, your investments in stocks.

No doubt about it. The current picture is gloomy. On Wednesday, WorldCom Inc. announced that over the past five quarters it had erroneously - and perhaps fraudulently - treated $3.9 billion in operating expenses as if it were capital investment. Because capital costs are depreciated - that is, written off over many years - they don't reduce earnings all at once, the way operating expenses do. As a result, WorldCom produced a profit of $1.8 billion for that period when it should have registered a loss.

With the first half of 2002 over, stocks have turned in a truly miserable performance. The benchmark Standard & Poor's 500-stock index has fallen almost 14 percent, after losses of about 10 percent in 2000 and 13 percent in 2001. If the full year produces another decline, it will be the first three-year string of losses since 1939-41. The tech-heavy Nasdaq composite index, meanwhile, is down by nearly three-quarters from its high in spring 2000.

That's the bad news. How could there possibly be any good news? Read on.

The economy. On Thursday, the Commerce Department reported that the gross domestic product (GDP, or total output) grew at an annual rate of 6.1 percent in the first quarter of 2002. That's a huge number - about twice the average U.S. growth rate since World War II and the best quarter in the past two years. Consumers keep spending (the rise was 3.3 percent - not too hot, not too cold). Houses keep selling (the latest figures show a record number of new-home sales). Durable-goods orders keep flowing (Wednesday's number was higher than expected). Unemployment keeps falling (it's now below 6 percent; the United States lost about a million jobs from October to March, but since then employment has been rising). Personal income keeps increasing (it's up at a nice 3.1 percent over the past year). And productivity - the amount of output for a unit of input - is sensational (8.4 percent in the latest quarter). Inflation is tame, interest rates low, chain-store sales robust.

A strong economy means strong profits, and profits are what eventually determine stock prices. The brilliant financial analyst Benjamin Graham, Buffett's mentor, once said that in the short run "the stock market is a voting machine" but in the long run it is "a weighing machine." In other words, emotions can move stock prices briefly, but in the long term it's real profits that count.

The mystery of this business cycle is that stock prices have not risen with the recovering economy. Investors, shellshocked by terrorism and scandals and by the first recession in a decade, are demanding, "Show me the money!" That is, they still aren't convinced the economy is on the right track. Business spending hasn't recovered, and the dollar is falling.

All is not rosy. It never is, but on balance this is the sort of economy associated with a long-term stock market advance, not a decline - unless, of course, the market is telling us that the nascent recovery won't last. I doubt that's the case. Look at recent history: The U.S. economy has been surprisingly resilient for the past 20 years. Since 1982, the gross domestic product has declined in only one calendar year (1991, by 0.5 percent), and stability - in inflation, interest rates and growth - has been the primary theme. Betting against the American economy has been a losing proposition. Zip factor: 8 (out of 10).

Politics. Half of all American families own stocks, and politicians, more than ever, have an incentive to keep them happy. A rising stock market will make accounting concerns disappear. President Bush understands that, and it's likely he will do all he can to boost the economy and share prices. The Federal Reserve Board is not supposed to be influenced by politics, but everyone, even Alan Greenspan, likes to be loved. Expect stock-friendly policies from Washington. Zip factor: 4.

Undervaluation. Stocks are cheap compared with other investments. Bonds and cash are not attractive. Money-market funds and short-term Treasury bills are yielding only a percentage point or two. Two-year notes are paying only about 3 percent; five-year notes, 4 percent. That's a paltry yield. Consider the quick-and-dirty Fed Model, which compares the return on a 10-year Treasury bond with the return on stocks.

Right now, the T-bond yields 4.7 percent, or just $47 for every $1,000 invested. Stock returns are much harder to calculate because the recession has depressed profits well below typical levels. My own estimate is that, based on "normalized" earnings for this year, the price-to-earnings (P/E) ratio of the S&P is about 20. Turn the P/E upside down and it becomes an E/P ratio - that is, earnings divided by price, or earnings yield - a number you can easily compare to a bond yield.

If the P/E is 20/1, then the E/P is 1/20. In other words, stocks (at 1/20, or 5 percent) are yielding more than bonds. And there's a big additional advantage stocks have over bonds: Profits tend to rise, while the interest on a bond stays the same. If profits increase at 7 percent annually, they'll double in 10 years. So instead of 5 percent, your earnings yield is 10 percent. But with a bond, it remains 4.7 percent.

Here are some enticing E/Ps, based on stock prices on Thursday and earnings for the previous 12 months: International Business Machines, 5.7 percent; Merck & Co., 6.3 percent; Toyota Motor, 5 percent; Sears, Roebuck, 5.1 percent; Deutsche Bank, 11.6 percent; Citigroup, 7.9 percent; Philip Morris, 9.4 percent.

Another measure of value - especially comforting at a time when many investors are questioning the accuracy of accounting statements - is the dividend. It's cold, hard cash. Among the solid stocks with good dividend yields currently are UST, which makes smokeless tobacco products, 5.5 percent; Duke Energy, North Carolina-based power company, 3.5 percent; Worthington Steel, 3.7 percent; Western Pharmaceutical Services, 2.5 percent; and BB&T, regional bank, 3.1 percent.

While profits overall have dropped by one-fourth during the past year, many companies continue to increase their earnings at a double-digit clip. Among those recently cited by Sanford C. Bernstein & Co., an investment research and management firm with a reputation for circumspection, are Kohl's Corp., a middle-market retailer; Freddie Mac, mortgage finance; UnitedHealth Group, managed care; and Pfizer, pharmaceuticals. All these stocks have fallen lately. Kohl's is down more than 10 percent since late May; Freddie Mac lost a tenth of its value in just the past week; UNH, a big winner this year, nonetheless fell 7 points between June 19 and 25; and Pfizer has fallen by one-fifth since February. Zip factor: 5.

Risk and reward. Never forget that stocks are risky. The question is whether the risks are worth taking to achieve the rewards. Nearly always with stocks, the answer is "yes." Since 1926, the average stock has returned more than 7 percent after inflation while intermediate and long-term Treasury bonds have returned about 2 percent. And, if you hold a diversified portfolio of stocks for the long term (10 years and more), their riskiness - that is, the extremes of their ups and (especially) downs - is about the same as that of bonds. The risk-reward relationship for stocks, in other words, has been sensational.

What about today? There's no doubt that some risks have increased - for example, the risk of terrorist attacks and perhaps the risk of getting inaccurate information from companies about their financial condition. But potential rewards have also increased.

Take Fisher Scientific International, a company rated "1" (tops) by the Value Line Investment Survey, an indication that it is among the 100 most timely stocks in the market. Fisher stock has fallen by one-third since February, but, as Value Line's Jennifer L. Wagganer puts it, the company's "sales and earnings seem poised for solid advances this year" - probably 15 percent to 20 percent. Two years ago, Fisher traded at nearly $50 a share and was earning 95 cents, for a P/E of about 50. Fisher now trades at $27 a share and is expected (for the full year 2002) to earn about $1.69, for a P/E of 16.

There are definitely dangers with Fisher, which distributes 600,000 laboratory, educational and clinical products in 145 countries. The company carries a lot of debt, and its business could falter if the economy turns down or terrorism increases. Risks are higher today, both for Fisher and the entire market - but rewards appear to be higher still. Zip factor: 6.

Enough, already! Dan Sullivan, editor of the Chartist, a 33-year-old newsletter with an excellent track record, told readers a few months ago to get out of stocks. But in the latest issue, while still advising caution, he writes: "The pervasive mood is gloom and doom for all the headline reasons: terrorism, corporate scandals, accounting improprieties, Wall Street hypesters, growing debt problems - and the balance of trade deficit. It is exactly this kind of scenario that creates buying opportunities. In the 1973-74 meltdown, we had the oil embargo, inflation, price controls, Yom Kippur war, Watergate hearings, and the Nixon resignation on Aug. 8, 1974. By early October, the S&P bottomed, setting the stage for a new bull market."

Yes, indeed. From October 1974 to December 1976, the S&P rose 85 percent. The last bear market, in the summer and fall of 1990, took the Dow from 3000 to 2365. By July 1998, it had quadrupled. The last time stocks fell three years in a row, they dropped a total of 21 percent. But the next year, they rose 20 percent and continued on a four-year streak, returning 147 percent in all.

"The irrefutable truth of the matter," writes Sullivan, "is that bear markets invariably set the stage for the next bull market."

But when will the bear market end? No one knows, but the worse people feel about stocks, the closer we are to the bottom. What many analysts want to see is something called "capitulation" - when investors throw in the towel and say they never want to see another stock again. We're close to that point. It looked like we may have reached it on Wednesday, with the WorldCom debacle - though some observers (me included) would rather have seen a huge blowout, a decline of, say, 500 points in the Dow.

Still, the UBS index of investor optimism just registered the second-lowest figure in its six-year history (the lowest was last September), and a recent study by Charles Schwab found rich investors especially sour on stocks. Sentiment among investment advisers has turned decidedly bearish but, according to analysts such as Sullivan, it's still "far too bullish." Why is bearish sentiment a good thing for stocks? It means that lots of cash is sitting on the sidelines and that prices are low enough to draw buyers. All that's needed is a catalyst - like a surprisingly good earnings report from a big company. Zip factor: 7.

Asked once whether he thought it would ever stop raining, Mark Twain replied, "Always has."
The same with declining stocks. The slide ends. Or at least, it always has - and usually with a bang. After the market fell a total of 37 percent in 1973 and 1974, it jumped a glorious 42 percent in the first six months of 1975. No one said that making money in the stock market was easy. It's in trying times like these that you earn your keep, through discipline, wisdom, moderation and patience.

A version of this article appeared in the Washington Post.



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