The outlook for US securities

Louis Proyect lnp3 at
Wed Jul 17 08:31:56 MDT 2002

WSJ, July 17, 2002

Market Medicine: Investors Look
For a Cure to the Stock Malaise


What will it take to get stocks moving up again? Surprisingly, the
solutions seem a lot clearer than they did just a few weeks ago.

Then, many investors saw the stock market as a conundrum: Economic forces
such as industrial production and consumer spending were strong and money
was flowing into mutual funds. Normally, trends like that would be sending
the stock market ahead, and yet stocks couldn't seem to get going.

Now, as stocks have stumbled into one of their worst slumps in 30 years,
investors are coming to believe they are dealing with something more than a
garden-variety decline. It now seems possible that the bursting of the
late-1990s stock bubble has created a set of persistent market forces that
will need to be dealt with and resolved before stocks can truly recover.

Over the past two weeks, the Dow Jones Industrial Average has fallen more
than 900 points, nearly 10%, including a 166.08-point decline Tuesday. The
power of the selloff has, for many, helped clarify how deep the market's
problems are. That, unfortunately, is the good news.

The bad news could be that the fix won't be quick. Of the major factors
shaping the market now, two of the most important -- disagreement about how
much stocks are really worth and a lack of trust in corporate numbers --
could take months, or perhaps longer, to overcome.

In addition, fundamental shifts such as less U.S. stock investing by
foreigners and a surge in trigger-happy hedge funds have fed the decline,
and could make climbing out of it that much tougher. All of this helps
explain why the markets, which only a few months ago were rebounding, have
faced such carnage. The Dow industrials are down some 20% over the past
four months.

All this gloom could be overdone. The stock slaughter of recent weeks could
mark the building of a so-called bottom, setting up the market for a steady

But a look at similar periods in the past suggests the rebound could take
longer than the optimists hope. "This is the down-leg of a great bubble,"
says Ben Inker, the bearish director of asset allocation at Boston
money-management firm Grantham, Mayo, Van Otterloo & Co. "History always
has said that the great bear markets take their time."

Rethinking Trust in the System

Three decades ago, investor Ron Bunten started working with a broker to
pick stocks he thought would beat the market. Over the years, many did,
especially in the boom years of the late 1990s.

Then came a telecom crash and a raft of corporate scandals that have helped
to wipe out the most speculative part of his portfolio, which included
Global Crossing and WorldCom. "They've all pretty much gone down the tube,"
says Dr. Bunten, 66, who retired this year as an orthopedic surgeon in Des
Moines, Iowa.

His faith in investing is gone, too. Today, Dr. Bunten is out of the
stock-picking game. He uses a conservative local investment firm to put his
savings in a mix of bonds and stocks that simply track broad markets around
the world.

No factor is more powerful in today's market than the crisis of confidence.
Analysts say questions of trust not only have undercut investors'
willingness to step in and buy stocks that look cheap, but also have sown
skepticism about whether companies that seem to be on the mend can really
be believed.

It reminds Steve Leuthold, chairman of Minneapolis money-management firm
Leuthold Weeden Research, of the 1970s, the last time stocks went into a
prolonged bear market. "You wiped out a whole generation of equity
investors there that never came back," he says.

Then, Mr. Leuthold was managing a mutual fund whose stocks were going up.
But when he would show up for work, he would find that investors were
pulling out anyway, moving to the safety of money-market funds.

Whether things get that bad remains to be seen. They may not, in part
because investors have few other places to turn. Foreign stocks are weak
and money-market funds offer puny returns.

But even professional investors are gun-shy. In a survey by Thomson
Financial, the great majority said they now look for accounting red flags
before they will buy a stock. Asked about market prospects, some said the
basic requirements for a recovery now are simply time and patience. Said
one: "It will take several more years to work off the 1999-2000 valuation
excesses, especially in tech."

Wondering What Stocks Are Worth

Most investors have accepted the painful truth that the most popular stocks
of the 1990s weren't worth what people thought they were. That doesn't
offer much consolation to investors today, who are more confused than ever
about what stocks are really worth.

Uncertainty about how to value a stock, post-bubble, is at the heart of why
people are having a hard time committing new money. Mr. Inker at Grantham
Mayo figures companies in the Standard & Poor's 500-stock index still are
too expensive and the index could fall an a further 20%. But veteran UBS
Warburg investment strategist Edward Kerschner believes stocks are
dramatically undervalued. He sees the possibility of a 20% rise in the S&P
500 once investors see some positive corporate earnings news this year.

On paper, none of this should be so difficult to figure out. In the
simplest sense, stock prices are a multiple of expected earnings per share.
If a company is expected to earn $1 a share next year, and if investors
typically have been willing to pay 20 times earnings for its stock, the
shares should trade at $20. If the price gets well above that, it may be
too high, and if it's lower, there may be room to rise.

But investors disagree sharply now about some of the most basic elements of
this simple calculation. For one: How much are stock buyers willing to pay
for earnings in this new environment? The bulls think they'll continue to
pay more than 20 times earnings for the stocks in the S&P 500, which
currently trade at about 21 times. Skeptics think investors may be willing
to pay only 17 times earnings, or less.

There also is debate about how much companies are capable of earning. Chuck
Hill, director of research at Thomson Financial/First Call, has been
warning that Wall Street's earnings forecasts for the rest of this year are
far too bullish.

As the wave of scandals has deepened, there's even controversy over what
goes into earnings -- what to include or exclude in the calculation.
Standard & Poor's itself this year decided to change the way it calculates

All this assumes investors are prepared to heed earnings reports at all.
Says Mr. Kerschner: "People don't believe an analyst when he tells them
earnings are going to recover, they don't believe the chief executive when
he tells them the earnings have recovered, and they don't believe the
accountant when he confirms it."

Structural Shifts

Not all of the forces shaping stocks are external; some reflect shifts in
the internal workings of the markets. Among the most notable: an explosion
in hedge funds.

These private investment pools control $560 billion in assets, almost
double the amount two years ago. And in a down market, many shift heavily
from buying stocks to "shorting" them -- selling borrowed shares in hopes
of replacing them when they're cheaper. As the market has slid, money has
poured into these funds from institutions and wealthy individuals looking
for a haven. Sensing that stocks still have room to fall, hedge funds have
stepped up their selling, putting serious pressure on the entire market.

"A lot of people are shorting, whether they believe in it or not," says
Neil Weisman, general partner at one hedge fund, Chilmark 21st Century
Capital in New York. "Just like they played the momentum on the way up,
hedge funds are doing it on the way down."

The good news is that at some point, hedge-fund managers have to buy shares
to replace the borrowed ones they sold. Traders say "short-covering" is
partly behind wild trading days such as Monday.

The hedge funds' actions, in turn, affect those of mutual fund managers.
These managers feel pressure to beat or at least match major indexes. In
the late 1990s, this forced many to buy big stocks that dominated those
indexes, such as General Electric Co. and Cisco Systems Inc. But as the
market has fallen, some managers have dumped these same stocks to try to
keep from falling behind the indexes. Some have shifted into other market
segments, such as small stocks, that have done better. All this has created
something of a herd effect, with few investors willing to stand in the way
of a sliding market to buy big stocks even if they look cheap.

"The absence of that buying," says Kevin Johnson, research director at
Philadelphia money managers Aronson & Partners, "throws kerosene on the
fire and causes lots of volatility."

Meanwhile, institutional investors have become more short-term-oriented.
They feel pressure to sell stocks as the market falters rather than hold on
for the long haul, says James Paulsen, chief investment officer at Wells
Fargo Capital Management. He thinks this adds to the volatility, though it
eventually could turn around and help the market rebound.

As index investing and hedge funds have soared to prominence in the U.S., a
shift in foreign money has also changed the shape of U.S. stocks. Realizing
in the 1990s that returns in the U.S. outstripped those at home, foreigners
surged into U.S. stocks. Their purchases in 2000 almost equaled those of
U.S. mutual funds.

Now the money's going the other direction. According to the most recent
data, foreign investors put $26 billion in new money into U.S. stocks in
the first four months of this year, down from $47 billion in the like
period a year ago. Most analysts say the buying has slowed even more
dramatically in the past month and has likely turned to outright selling by
many big foreign investors.

If the dollar stops plummeting, these investors may come back. But because
the outlook for U.S. corporate profits is no better than the foreign profit
outlook, their buying may be meek.

"Foreign investors, especially European, are even more skeptical of the
U.S. stock market and U.S. economy" than U.S. investors, says Nicholas
Sargen, chief investment strategist at J.P. Morgan Private Bank. "The most
likely scenario is subdued foreign buying of the U.S. market for some time."

401(k) Money: Braking the Fall

There is at least one bit of good news: For all the things pushing down on
stocks, there's one important change that's helping cushion the decline: an
unceasing stream of investments into stock mutual funds through 401(k) plans.

The 35 million people who participate in these retirement plans continue to
use chunks of their paychecks for regular contributions to stock mutual
funds, even in the midst of the carnage. More than 65% of the new money
goes into stocks. "People listened to all the education in the last few
years," says David Wray, president of the Profit Sharing/401 Council of
America, a trade group. "Younger people put 90% of their new money into

Inertia is working in the market's favor. Most investors rarely change the
allocation determining where their money goes. Hewitt Associates, which
administers $75 billion of 401(k) plans for almost four million employees,
says even during some of the recent painful days, well under 1% of its
401(k) money has moved out of stocks. In total, more than $1.7 trillion is
piled up in these retirement plans.

Thomas Petrarca, a 45-year-old who has lost more than $150,000, or 15%, of
his portfolio this year, says he's still putting the majority of his
monthly 401(k) contribution into stocks. "I haven't bailed out. I think
we're close to a bottom," he says. "I'm investing for the next 10 to 15

Still, there are some troubling signs for the market. Figures compiled by
Hewitt show 401(k) investors now are putting 30.3% of their new
contributions in fixed-income investments, which is up from 27.2% in
January. During 17 of 20 trading days in June, more people moved money out
of stocks to bonds than moved money from bonds to stocks.

Concern about more such withdrawals leads mutual-fund managers to sell some
stocks to raise cash to pay off investors who want out. Traders say that
helps explain why some solid stocks that had been doing well, such as
defense and homebuilding shares, now are falling.

Some skeptics, such as Thomas McManus, market strategist at Banc of America
Securities, point to the growing disenchantment with stocks as a
paradoxically upbeat sign. Individual and foreign investors have a poor
track record, often leaving the market just as things hit bottom, such as
in October 1998. If they're souring on stocks now, it could be a sign that
the most entrenched optimists are throwing in the towel, suggesting that
there won't be terribly much more selling left.

But it's also true that disgust with stocks by such investors helped hold
the market back from 1966 to 1982. Since individual and foreign investors
play a bigger role in the markets today, if they lose faith, stocks could
suffer for years, some say.

"We would have fallen more quickly without this continuous flow of
investment," says John Vail of Mizuho Securities USA in Chicago. "If 401(k)
investors and those with automatic investment plans shift out of equities,
it would be very damaging to the market."

The Lessons of History

Every stock bubble is different. Some pop with a bang; others deflate
slowly. But one thing seems to be true for all of them: Repairing the
damage takes time.

After the 1929 crash, it took the Dow Industrials about three years to
bottom out, in 1932. Then it took 22 additional years to get back to the
1929 high, which finally happened in 1954.

When the "Nifty Fifty" bubble popped in 1973, the Industrials fell 45% in
just under two years, and then took eight more years to return to their high.

The Japanese bear market that began at the very end of the 1980s took more
than a decade to bottom out -- assuming it has done so. Just as markets
tend to go to extremes during booms, they tend to overshoot on the way down

This latest bubble in U.S. stocks was centered most heavily on the Nasdaq
technology stocks, whose rout has been thorough. The Nasdaq composite is
73% off its record of 5048.62 on March 10, 2000. The Dow Industrials are a
far smaller 28% below their peak, also hit in 2000. The S&P 500 is 41% off
its high.

So the Nasdaq drop is the big one. The Dow and S&P aren't down as much as
in other recent bear markets. The S&P 500 was off 48% in 1973-1974. The Dow
Industrials fell 36% in 1987.

Why the variation? Not all stocks are suffering. Those with dividends,
those whose prices are low relative to their earnings and those related to
real estate and construction have held up better than most. The real pain,
and the real skepticism about the future, lies with the Nasdaq technology
stocks. Few people expect any of the indexes to return to their old highs

"I may not even see us break 5000 in the Nasdaq again, and I intend to live
to 95," says Mr. Leuthold. He is 64 now.

Louis Proyect
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