Played by the ‘Rules’? You Probably Lost
Rules, as they say, are meant to be broken.
So it has been with the great stock surge of the 1990s: Time and again this market has defied long-standing rules about the “limits” of share prices.
“There are no more milestones” left to exceed, says Arnold Kaufman, editor of Standard & Poor’s Outlook newsletter in New York and a veteran market watcher.
Consider:
* An annualized dividend yield of less than 3% on the average blue- chip stock has historically been a signal that share prices were overvalued and ripe for a plunge.
But the Standard & Poor’s 500 dividend yield fell below 3% in 1991, and has continued to decline since. The yield (calculated by dividing the overall S&P; 500 annual dividend per share by the index’s price) is now at a record-low 1.7%.
Yet investors who abandoned stocks in 1991 because of the dividend rule have lost out on a 133% gain in the S&P; since.
* The price-to-earnings ratio, or P/E, of the S&P; 500 now stands at about 24, based on earnings per share of the S&P; companies in the four quarters ended Sept. 30.
That is the highest average blue-chip stock P/E of the modern era, except for a brief time in 1991 when the S&P; P/E neared 26 as stocks recovered before earnings did after the Persian Gulf War-triggered recession.
Many Wall Street pros were arguing that stocks were overpriced a year ago, when the S&P; P/E was about 20. But that didn’t stop investors from pushing prices higher, lifting the index another 31% last year.
* After stocks’ spectacular advances in 1995 and ‘96, some Wall Street bears invoked the “two-year rule”: Historically, the market has performed poorly in the year that follows two great years.
Prior to 1995, there were nine two-year periods since 1904 in which the Dow Jones industrial average rose 60% or more, according to market research firm Logical Information Machines in Chicago. The third year proved to be a loser in six of those instances, and in two other instances the Dow’s rise in the third year was minuscule. Only once did the third year see a terrific gain (in 1935).
The record books now will record that 1997, as well, defied the two-year rule: The Dow surged 22.6% last year after rising 33.5% in 1995 and 26% in 1996.
In 1998 the market confronts another long-standing rule: “the four-year-cycle rule,” which holds that stocks face tough times roughly every three to four years. That was true in 1994, 1990, 1987, 1984 and 1981, for example.
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As exceptional as the 1990s bull market has been, it merely extends what has been a phenomenal run for stocks since 1975.
Since then there have been just four calendar years in which the S&P; index fell in price. Even including the horrendous bear market years of 1973-74, since 1970 the market has closed up on a calendar basis 79% of the time.
That meshes with the long-term story of stocks, says Richard Eakle, head of market analysis firm Eakle Associates in Fair Haven, N.J.: “Seventy-three percent of the time the market is up,” he says--which is why so many pros advise people to stay invested.
The market’s tendency is to rise because the economy’s tendency is to grow, generating a greater number of successful companies. Their stocks just reflect their success.
Even so, stocks can get ahead of companies’ fundamentals. That was clearly the case in Japan by 1989: A decade of soaring share prices lifted the Nikkei-225 stock index to 38,915 by Dec. 29 of that year. Many Japanese stocks were priced at 60 times earnings or higher.
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The rest, of course, is history. Japan’s “bubble” economy collapsed in 1990. Today the Nikkei index, at 15,258, is 61% below its 1989 peak.
Could the U.S. market, too, have reached the bubble phase? Perhaps. But even at their current high P/E ratios, U.S. stocks are far below the valuations placed on Japanese shares at their peaks.
What’s more, bullish investment strategists, such as Goldman, Sachs & Co.’s Abby Joseph Cohen, argue that U.S. P/E ratios should be historically high, given the economy’s extremely low inflation rate, low interest rates, recently strong corporate earnings growth rates and the global shift to capitalism in the 1990s.
As for the low dividend yield on stocks, the cut in the capital gains tax rate last year made it even more unappealing to receive fully taxable dividends, versus owning stocks for appreciation potential.
Nonetheless, some veteran investors warn that severe market excesses often are visible only in hindsight. On Wall Street, as in real life, “you usually kick yourself [later] for not following logical” insights, S&P;’s Kaufman says.
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U.S. Stocks: A 28-Year Look
Since 1970 there have been just six calendar years in which the blue-chip Standard & Poor’s 500 stock index has fallen in price. Annual S&P; price changes:
(please see newspaper for full bar chart information)
1997: +31.0
Source: Standard & Poor’s Corp.
