Stocks Can’t Make Up for Low Savings Rates

There were white knuckles aplenty on Wall Street last week as stocks swooped and swooned in roller-coaster trading. By the time the Dow Jones Industrial Average finished at 6526.07 (a 559.90-point loss since the grim slide began on March 11), brokers and money managers were ready for a quiet weekend.

Through all the confusion, cooler heads warned against panic, pointing out that a correction of 10% is a healthy sign after the extraordinary gains of recent months. Some kind of correction was long overdue; the stock market hasn’t had a major correction since 1994--a modern record.

In any case, the triple-digit losses on the Dow are less dramatic than they look. With the Dow near 7000, a fall of 150 points represents only 2% of the market’s value. To match the percentage loss of the October 1987 crash, the Dow would have to lose about 1,425 points in one day.

This is all very true, and very reassuring, but the nervousness evident in trading last week should warn us that there could be trouble ahead.

After a 15-year bull market, the stock market has climbed to heights where the air is a little thin. Especially in the last 15 months, we have lived in the best of all possible worlds for stocks. Inflation and interest rates have been low, the economy is growing, and corporate profits are on the rise. When things can’t get any better, they can only get worse, and that, fundamentally, is why the markets are worried.

Most of the attention--and the worry--is focused on the Fed. Chairman Alan Greenspan has made it clear that he thinks current stock prices are too high, and, with the Fed also still worried about inflation, there is a real fear that last month’s interest-rate increase could lead to one or more sequels.

But there are other things to worry about. The current economic expansion is now 71 months old. Since World War II, only two expansions have lasted longer, and if the economy stays healthy until the end of President Bill Clinton’s second term, it will be the longest economic expansion in U.S. history. The law of averages suggests that, at some point in the not too distant future, the economic party is going to stop.

Even before that happens, investors could get some nasty shocks. Only very optimistic projections for future corporate earnings can justify current stock prices; if earnings are lower than expected, look for stock prices to fall, possibly very fast. While conventional market observers worry about how small investors could panic in a market correction, the real issue may be how mutual-fund managers and other seasoned pros will respond to bad news. As more and more money managers feel more and more pressure to equal or beat the broad market indexes, a herd mentality takes over. Hot stocks get bid up in a buying frenzy, as money managers try to jump on the bandwagon. Then if psychology changes, those stocks can drop with a thud.

Take Idexx Laboratories. As financial writer Christopher Byron reports in the New York Observer, this veterinary testing company was once the darling of the mutual-fund managers, but lost 64% of its value March 24, when it reported bad news on earnings. All the money managers tried to bail out at once. Byron warns that these devastating collapses could become more common as the bull market ages.

Small investors pose a different kind of problem for the market. Americans are saving less than they used to, and this may be driving unrealistic expectations in the stock market. The torrent of money rushing into mutual funds and helping to pump up the stock market comes from changing habits, not from higher savings. As a percentage of disposable income, personal savings have fallen from 9% in 1975 to about 5% today. Much of the money now going into the stock market is money that used to go into banks, and much of it is pushed by fear rather than greed.

The baby boomers, increasingly worried about retirement as they age, have seriously undersaved for their retirement. A couple in Southern California who wanted to maintain an upper-middle-class lifestyle in retirement need savings and pension funds equivalent to about $1.4 million.

Boomers, many of whom are putting children through college and or taking care of elderly parents, have not put this kind of money aside, and a kind of low-grade panic is building up. The stock market, where gains in recent years have far outpaced average long-term performance, looks to many cash-strapped boomers like a magical fix. A stock-market boom will, boomers hope, turn their meager savings into the substantial hoards needed for a secure and affluent retirement.

The shift of personal savings into the stock market has helped to raise demand for stocks and, therefore, their prices, but this increase is essentially a speculative bubble. People are buying stocks because they think their prices will continue to rise--just as people bought expensive homes during the real-estate bubble.

In fact, it is unlikely that stock prices will rise over the next generation as quickly as they have done in the last 15 years. For one thing, most economic experts believe the U.S. economy is slowing down. The average annual rate of GDP growth has been falling for 30 years, and consensus long-range forecasts assume the trend will continue.

If that happens, then, as EPI economist Dean Baker points out, corporate earnings and stock prices must also rise more slowly. If the assumptions about slow growth are right, stock prices are likely to increase only at about 4% a year.

International economic growth could improve this forecast for stocks, but with 30-year U.S. Treasury bonds now yielding more than 7% interest, we could be entering an era in which bonds are a better long-term bet than stocks.

None of this offers much solace to aging baby boomers, many of whom have put their retirement savings into aggressive growth funds in the hope of beating the market. Seven-percent interest, after inflation is factored in, is more like 4%; that kind of return won’t get baby boomers to Shangri La by age 65.

But the reality is that there aren’t any magic fixes. Boomers must save more now, even if this means reducing their standards of living. Saving more will allow them to invest more conservatively--accepting somewhat lower rates of return in order to minimize the risk of devastating losses.

Investors who have realistic goals and follow sound, long-term strategies can still do well in a turbulent stock market. Those who follow hot money managers and faddish investment theories in the hope of double-digit gains are, in this market, likely to pay a high price.