For Market Bears, History Soothes--but It Also Traps
It’s probably fair to say that Jim Stack’s idea of a great U.S. stock market doesn’t jibe with that of most hard-working Americans.
Stack, a veteran market analyst who writes the InvesTech newsletter from Whitefish, Mont., believes that a “fair” value for the Dow Jones industrial average would be about 4,800.
That would be a 55% discount from Friday’s Dow close of 10,649.76. Just imagine your stock mutual funds or 401(k) account worth about half what they are today. There you have Stack’s concept of a good time.
Stack is not a crackpot. I’ve been reading his investment newsletter since the 1980s. He writes well, and thoughtfully, about the stock market and the economy. His knowledge of market history is vast.
But he also has been dead wrong about stocks’ direction for most of the 1990s. He turned bearish in 1993. I interviewed him for an extensive story in July 1996, and he was convinced then that the market was nearing collapse. That was 5,200 Dow points ago.
Today, the 48-year-old Stack is largely unrepentant--and more bearish than ever. The $40 million he manages for clients is about 50% in cash. The rest is invested in a relative few stocks, in gold-stock funds and in Japanese funds, as well as in some mutual funds that represent a “short sale” bet on the U.S. market (a bet on falling prices).
Even so, Stack concedes that he would have been much better off in recent years had he been more flexible in evaluating the market’s prospects. He made a classic mistake: He opposed a trend that was growing exponentially in power.
Most people have simply gone with the flow--the mighty flow of factors pushing stocks ever higher since 1994. Stack tried to fight that flow because his historical reference points told him that stocks shouldn’t be at those (or these) levels, and couldn’t possibly exceed them.
“It’s a new era!” Wall Street’s bulls have proclaimed over and over: a low inflation, high productivity, high corporate profitability, demographically favorable era in which stocks deserve to sell for seemingly outrageous valuations.
“It’s not a new era!” bears such as Stack have insisted. There are never new eras for stocks, he argues--just periods in which the market becomes excessively overvalued or excessively undervalued before returning to some semblance of normalcy.
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But what’s your definition of an “era”? In the modern age, I think there’s a good case to be made that even four years can constitute an era. Through 1998, we had four years of generally spectacular stock market gains driven by the new-era factors cited above by the bulls.
If that wasn’t an era, it certainly has been an eternity for anyone who has been bearish on stocks.
Whatever you call this period, it won’t last forever. It will give way to something else. But what? An even more dramatic market surge? A sideways-moving market for a few years? A classic bear market, wherein the Dow and other market indexes lose more than 20% of their value over an extended period?
The Dow, which last week posted its best weekly gain since July, now sits 6% below its record high of Aug. 25. The Nasdaq composite, lifted by technology and Internet shares, ended Friday less than 1 point from its record closing high reached Sept. 10.
The market overall, however, has in recent months been far weaker than those indexes would suggest, weighed down by rising interest rates, a sliding dollar and other problems. Stack, not surprisingly, seizes on that broad market weakness as evidence that the 9-year-old bull run is in its death throes.
His reasoning, as always, is rooted in history’s lessons:
* Only a handful of stocks, and mainly such names as Microsoft and General Electric, have accounted for the majority of the gains in key stock indexes such as the Standard & Poor’s 500 and Nasdaq composite this year, Stack points out.
Even last week, when the S&P; jumped 4.2% and the Nasdaq index rose 5.5%, the number of stocks rising barely outnumbered those falling in the market as a whole.
The action reminds Stack of 1972, when Wall Street was led by the so-called Nifty Fifty blue chip stocks, while much of the rest of the market peaked out. In January, 1973, when the Nifty Fifty finally began to roll over, the market began a decline that turned into the worst bear market since the 1930s.
* Other than a relative few blue chips, the only stock sector attracting significant dollars during the last two months has been the sector that is arguably the most speculative corner of the market: the Internet stocks.
The Interactive Week index of 50 Net-related stocks rose 1.3% on Friday to 354.64. After a steep summer slide the index has rocketed 40% since Aug. 9 and now is just 1% below its record high reached April 26.
The Net stocks’ true believers say it’s logical that these stocks are leading the market again. The Internet is the future! Duh!
But Stack sees only the dark shadow of the past. The mania for Net companies, most of which have no earnings and may never have any, reminds him of the “letter-stock” craze of the late 1960s. Those were shares sold privately by hot growth companies of the era to the hot investment funds of the era.
Many of those stocks became worthless. The difference between then and now, Stack says, is that institutional money managers financed the letter-stock boom. This time, the individual investor is the driving force pushing Net stock prices into the stratosphere.
“Today, most of the garbage is going public,” Stack says derisively of extremely high-risk companies.
Someday, he says, investors will look back and wonder how securities regulators allowed the public’s money to be taken by so many untested businesses.
“It almost borders on criminal neglect that the Securities and Exchange Commission hasn’t [applied] some kind of standard” to Net stock offerings, Stack says.
* If he can take bearish comfort in nothing else, Stack need only retreat to the standard market valuation yardsticks--all of which show that stocks are at extraordinary heights viewed historically.
The price-to-earnings ratio of the S&P; 500 now is 32.5 based on the earnings of the companies during the most recent four quarters. The 70-year average P/E: 14.6.
The S&P;’s price-to-book value ratio is 6.3, which means that for every $6.30 in share price there is just $1 in net assets for shareholders. The historical average: a 1.9 ratio.
And relative to annual dividends the S&P; companies pay, the average stock is valued at more than three times the historical norm.
“You just can’t have valuations rise forever,” Stack says.
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He’s right, of course. But let’s assume this is a peak. For valuations to fall, stocks could dive--that would be the easy way.
Or stocks could essentially go sideways for years while earnings, dividends and asset values rise.
Stack doesn’t believe the latter can occur. “Built into the speculative episode is that the unwinding will not come gently,” he says.
But does he really believe that stocks overall must revert to historical norms? There are, after all, good reasons some things don’t happen again--such as bad 1970s hairstyles.
Who says that investors have to learn to care about dividends again? Who says that the public shouldn’t play a venture-capital role in the stock market, if that’s what they choose to do with their money?
Most people shouldn’t gamble in Las Vegas, either. But they do, and more than ever.
No one should argue that we’ll never have another bear market. But the degree to which Stack believes the market could, or should, decline is quite contestable. A Dow of 8,000 would probably mark emotional devastation for many investors, even if that doesn’t approach stocks’ old valuations. And for many battered stocks, we’re already at the equivalent of Dow 8,000, or lower.
Stack agrees that the market may never fall to the level he would view as “fair.” Still, he says, “I want to see a resolution of the excesses.”
He is motivated, he says, primarily by his knowledge of how much has been lost following previous hot markets. “I know too much about history,” he says.
But he also concedes: “My biggest problem is that I’m trapped by history.”
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The S&P; 500: Today vs. History
Most investors know that stock price valuations are “high” historically. But how high? Here’s a look at three classic valuation ratios for the blue-chip Standard & Poor’s 500 index: price-to-earnings, price-to-dividend payments and price-to-book value (the net asset value of the underlying companies): Price-to-earnings Today: 32.5 70-yr. avg. 14.6 Price to Dividends Today: 80.3 70-yr. avg. 25.9 Price-to-book value Today: 6.3 70-yr. avg. 1.9 *
Source: InvesTech Research *
Tom Petruno can be reached by e-mail at tom.petruno@latimes.com.
