After 12 years, bulls see stocks coming out of rut
The U.S. stock market held up remarkably well in 2011 considering what was thrown at it.
But the market’s harrowing ride during the 12 months was a painful reminder of what many investors have endured for the last 12 years: a lot of wild moves, and in the end little net progress.
The Standard & Poor’s 500, the benchmark index of the nation’s best-known shares, finished last year almost exactly where it began.
More distressing for the ranks of long-term investors is that the S&P index is barely above where it was at the end of 1998. The Dow Jones industrial average, at 12,359 on Friday, has risen a mere 5.4% in price since early 2000.
Technically speaking, stocks have been in a new “cyclical” bull market since rallying from their recession lows in the winter of 2009. But the bigger picture is that Wall Street still seems firmly in the grip of a “secular” bear market — a long period in which prices of many stocks either decline or, at best, go sideways.
This is the third such period since 1920. The first was from 1929 to 1949: the Great Depression years, World War II and its immediate aftermath. The second was from 1966 to 1982, a time of soaring inflation and economic stagnation.
For investors trying to decide whether equities are worth the risk, the secular trend is of course a critical issue. If you don’t believe that share prices can be significantly higher in 10 years, what’s the point of owning them?
Market professionals acknowledge U.S. blue-chip stocks’ dismal performance over the last decade, but many also see it as a stronger argument for buying than for selling. After all, secular bear markets eventually should give rise to new secular bull markets. The longer stocks struggle, the closer they should be to breaking out of their malaise.
“If we look back in a few years this could be one of the rare opportunities to buy stocks,” said Ed Clissold, global equity strategist at market research firm Ned Davis Research in Venice, Fla.
But even the optimists temper their enthusiasm about the market’s prospects, as the developed world struggles under the mountain of debt built up over the last 30 years. Almost no one believes that stocks are on the verge of a long-term surge similar to the spectacular 1982-to-1999 bull run, which followed the go-nowhere market of ’66 to ’82.
“I’m not saying equities are going to be great. I’m saying they can be the best return in a bad neighborhood,” said Bob Doll, chief equity strategist at money management titan BlackRock Inc. in New York.
With interest rates on high-quality bonds near generational lows, and with cash accounts paying near zero, even if the percentage return on stocks averages only in the mid-single-digits over the next five to 10 years that could look good in comparison.
Still, the risk of steep losses is ever-present in equities — which investors were reminded of last year. As Europe’s government-debt crisis worsened and many emerging-market economies slowed amid rising inflation, stock markets worldwide ended broadly lower in 2011.
The average foreign-stock mutual fund slumped 14% for the year, the first annual decline since the market crash in 2008, according to data firm Lipper Inc.
U.S. stock funds in 2011 mostly fared better than their foreign rivals, in part because some frightened global investors sought American securities as a relative haven. Also, as the U.S. economy defied predictions that it would fall back into recession in the second half of the year, and as corporate earnings overall continued to rise, the market rebounded from its lows reached in October.
Most broad categories of domestic stock funds were down between 1% and 5% for the year.
“The market has been surviving a crisis of confidence more than a crisis of the economy,” said Jim Stack, who manages $700million for clients at InvesTech Research in Whitefish, Mont.
Despite signs of underlying strength in the economy, Americans’ confidence about the future remains weighed down by still-high unemployment and underemployment, the deeply distressed housing market, state and local government austerity and the bitter partisan battles in Washington.
What’s more, with stocks suffering two horrendous crashes in nine years — the 2000-02 plunge and the 2008 collapse — some investors are unwilling to take the chance that another dive could be on the horizon.
For the fifth straight year in 2011, conventional stock mutual funds that own U.S. stocks saw more money flow out than in. The funds had net redemptions of $115 billion in the first 11 months of the year, or 2.8% of total assets, according to the Investment Company Institute. That followed outflows of $28billion in 2009 and $95billion in 2010, even as the markets recovered.
By contrast, investors have continued to pour savings into bonds. Most types of bond mutual funds posted positive returns in 2011. Funds that own high-quality U.S. government, corporate or municipal bonds got a boost as market interest rates defied widespread expectations and continued to fall, lifting the value of older fixed-rate securities.
Stock market optimists know they can’t argue with bonds’ appeal to millions of risk-averse Americans. But the further interest rates fall, classic investment theory holds that stocks become more attractive — in part because competing bond yields offer lower future returns.
The S&P 500 index’s dividend yield — the annual cash dividend paid by the companies, divided by the index’s market value — now is 2.09%. That beats the 1.96% annual interest yield on 10-year U.S. Treasury notes.
Historically, an S&P dividend yield above the T-note yield “usually tends to be a buying opportunity in stocks,” said Sam Stovall, chief investment strategist at S&P in New York.
More critical to many professional investors is stocks’ attractiveness based on a standard measure of value: the price-to-earnings ratio, or stock price divided by underlying earnings per share.
Secular bear markets typically follow market booms that push stocks to high prices compared with companies’ earnings power. A high P/E ratio often means investors are betting on heady long-term earnings growth from a company. At peaks of optimism, no price seems too much to pay.
But after boom inevitably turns to bust, chastened investors slash the prices they’re willing to pay for stocks relative to earnings.
“Since 1998 the market has gone nowhere. What has changed drastically are valuations,” Stack said.
The P/E ratio of the S&P 500 index peaked around 30 in early 2000 based on companies’ operating earnings over the prior four quarters, according to S&P data. Now, the S&P 500 P/E is about 12, as prices of many stocks stalled or lost ground last year while earnings continued to grow.
“In 2000 stocks were ridiculously expensive,” Doll said. “Now, if they aren’t cheap they’re inexpensive.”
Still, history shows that P/E ratios can fall much lower in secular bear markets as many investors stay away from stocks.
“P/Es have contracted mightily but not back to what they were in 1982 or in 1942,” Clissold said. “They were single digit back then.”
Could stock valuations get that low again before the secular bear market runs its course? Stack believes that institutional investors would find stocks too appealing to tolerate single-digit P/Es for long, given near-zero returns on cash and low interest rates on high-quality bonds.
But any bet that stocks are cheap at these levels also must assume that profit growth will continue, with S&P 500 earnings already nearing record highs. If the U.S. economy begins to slide anew in 2012, earnings expectations could quickly tank.
The pessimistic case is that the potential reward from buying at these market levels is simply too low compared with the risk that the secular bear has much further to run, with the global economy facing extraordinary head winds.
For individual investors, avoiding stocks certainly is an option. But even if the market remains stuck in a seesaw pattern for years to come, in times when shares are rallying — as in 2009 and 2010 — it can be difficult psychologically to sit on the sidelines. The danger is that small investors will be pulled in just near the high points of short-term rallies.
Without a crystal ball to pinpoint the date of this secular bear market’s final gasp, here are three strategies to consider:
Stay cautious — and diversified: Many people already have pared their stock holdings significantly in favor of holding bonds or cash. The new year is a good time to consider whether you’re still comfortable with the percentage of your assets in equities.
At the same time, recognize that there may always be some sectors of the market doing well. Even as the S&P 500 index went nowhere from 1999 through last year, an S&P index of 400 mid-size company stocks gained an average of 7.2% a year in the same period.
“Your performance over the last decade should be a lot better than the S&P 500 if you were diversified,” said Russ Kinnel, head of fund research at Morningstar.
Last year the S&P 500 overall was flat, but seven of 10 industry sectors in the index posted gains — including utility stocks, up 14.8% on average, and healthcare stocks, up 10.2%.
Focus on dividend income: Investors who have the wherewithal to build portfolios of individual stocks or exchange-traded funds can easily find blue-chip issues with dividend yields in the 2% to 4% range. One advantage dividends have over bond interest: Dividends can rise, while interest earnings stay fixed.
Not surprisingly, the dividend-focus strategy already is quite popular on Wall Street. But that doesn’t mean it’s played out. David Rosenberg, chief investment strategist at wealth manager Gluskin Sheff + Associates in Toronto, is bearish on the economy but still sees appeal in high-income-paying securities of big-name companies that have strong finances (i.e., low debt).
He calls it his SIRP strategy: “safety and income at a reasonable price.”
Try to be a disciplined opportunist: Trading short-term rallies within secular bear markets always looks easy in retrospect. But in seesawing markets, the advantage goes to the investor who can stay disciplined about buying favored securities when they tumble.
If you’re buying mutual funds via a 401(k) retirement plan, you’re already an opportunist: By investing the same amount every paycheck, your plan contributions will buy more fund shares when they’re depressed and less when they’re high.
Likewise, investors who use so-called target-date retirement funds are automatically maintaining a specific stock-and-bond mix that will shift over time according to a preset formula.
“The funds allow people to be more disciplined than our emotions will allow us to be,” Kinnel said.
