Emotions Rule Nation’s Financial Heart

In the days of 1,500 on the Standard & Poor’s 500 index and 5,000 on the Nasdaq composite about 18 months ago, the U.S. stock market was priced for a perfect world.

That perfect world is long gone, and so are those share prices. Now the challenge for investors is deciding what are fair stock prices for a world that became a whole lot scarier on the morning of Sept. 11--but a world that nonetheless continues to turn.

Last week, many institutional investors clearly were choosing to sell first and ask questions later about what might be truly fair share prices. New York Stock Exchange trading volume hit record levels as stocks plunged upon reopening from the four-day closure forced by the terrorist attacks.

On Friday the Dow Jones industrial average fell 140.40 points to 8,235.81, extending the loss for the week to 14.3%. That made it the second-worst weekly loss in the Dow since at least 1915.

The Standard & Poor’s 500 index ended Friday at 965.80, down 11.6% for the week. The Nasdaq composite fell 16.1% for the week to 1,423.19.

Like the Dow, the S&P; and Nasdaq indexes are at their lowest levels in nearly three years.

Many investors would be thrilled if their stocks were only at three-year lows. The damage is much worse for some: Walt Disney shares fell last week to levels last seen in 1995. Ditto for oil field services giant Halliburton. Delta Air Lines stock was at its lowest since 1994. Eastman Kodak shares haven’t been this low since 1993.

But “low” in this context refers only to the nominal share prices. “Low” and “cheap” often are two different things in the equity market. Just because a big-name stock has fallen, say, under $10 or $15 a share, doesn’t necessarily mean it’s cheap.

In the perfect world of winter 2000, when few investors paid much mind to classic yardsticks of share valuation such as price-to-earnings ratios, a high stock price was a sign of a winner--because what already was high seemed destined to go higher.

Now, many investors look at stocks that have collapsed not as potential bargains but as issues that may well go much lower. Airline shares, in particular, have been decimated. Many lost half their value last week alone amid fears that the industry faces a long-lasting decline in travel and heavy new government involvement in the business.

But all airlines weren’t equal before the terrorists struck, and they won’t be equal in the world that awaits the industry. America West Holdings, whose shares closed the week at $2.50 each, down 71% in five days, is being treated like a bankrupt.

Rival Southwest Airlines, by contrast, is viewed as virtually certain to be a survivor thanks to its strong finances, but even its shares were off 21% last week, to $13.60 by Friday. They’re down 42% from their peak reached earlier this year.

If the stock market wasn’t hit by institution-led panic selling last week, it was as close to panic as many people probably would care to get. Market panics are nasty affairs and, obviously, produce severe financial losses. But they also produce opportunities. Stocks can be for sale at prices that, in retrospect, will look incredibly appealing.

Three years ago, in the wake of Russia’s debt default, panic selling hit most stock markets worldwide between August and early October. The global financial system suddenly seized up as investors refused to buy the bonds of emerging-market countries. The near-failure of a major hedge fund, Long-Term Capital Management, triggered widespread fears of domino-style bank and brokerage failures.

Compared with the terrorist attacks, the 1998 financial crisis was a stroll in the park, at least from the perspective of most individual American investors. Indeed, many investors had little idea what was happening in the financial system at the time, or why they should care. There was no evident negative effect on the U.S. economy, and there were even some benefits--such as falling mortgage rates as they tracked a steep drop in Treasury bond yields.

But in the stock market the S&P; 500 index plummeted 10% between Sept. 23 and Oct. 8, 1998. The Nasdaq composite fell 19% in the same period.

Many financial services stocks suffered much bigger declines. Shares of Merrill Lynch, for example, lost nearly two-thirds of their value between early August and early October.

As it turned out, some stunning bargains were created by that panic. Merrill shares bottomed at $18.88 on Oct. 7, then rallied back to $37.50 by the end of November, for a 99% gain.

Then, as now, the Federal Reserve was flooding the banking system with money to keep the cost of credit down and encourage banks to keep lending. The panic passed in 1998 and markets recovered.

This time around Merrill Lynch shares have dropped to $37.65 (as of Friday), a loss of 30% since late August and a drop of more than 50% from the all-time high of $80 reached in January.

Is Merrill a bargain at this price? Measured by its P/E ratio, the stock now is priced at 11 times the $3.45 a share that analysts, on average, expect the company to earn in 2002, according to estimate tracker Zacks Investment Research.

That still is far higher than the P/Es investors were willing to pay for Merrill in the early and mid-1990s, though it is below the “perfect world” P/Es of the late ‘90s. At its high price in 2000 the stock’s P/E was 18 based on that year’s earnings.

But profit estimates for Merrill, as for many or most other companies, are extremely tenuous. A bona fide U.S. recession may already be underway. The economy’s prospects for 2002 are murky at best. Who really knows what earnings will look like next year?

What’s more, the nation is at war, and with an enemy it can’t easily locate. President Bush has warned Americans that this war will go on for a long time. The cost to the government and the economy, and the toll in human lives and on the nation’s psyche, can only be estimated today--and as with company earnings, those estimates are subject to constant revision.

Identifying stock bargains in this new world order is a high-risk endeavor. If you buy too early you may lose quite a bit, at least on paper, before a stock finally bottoms.

Nonetheless, investors have to assume that the world will go on and that many solid U.S. companies will survive this struggling economy and will be generating decent earnings for shareholders in a year or two.

Another reasonable assumption is that the big investors behind last week’s selling haven’t been dumping stock entirely because they want to; it may be that many feel they have no choice but to raise cash, just to be prudent. Their view of the future may be no clearer than yours--they just have more money at stake and thus have a greater effect on share prices when they act.

If institutional investors were perpetually brilliant, they wouldn’t have been jettisoning Merrill Lynch stock in 1998 at prices under $20 a share. They may well be making similar miscalculations today, and on a grand scale with high-quality stocks.

Time horizon is the key here: Bargain-hunting in this market should be done with the goal of making money in two, three, even four years, not in two or three months.

Take Southwest Air as an example: The stock peaked at $23.33 earlier this year. If the price can get back to that level three years from now the gain would be 72% from Friday’s close, or the equivalent of making more than 20% each year for those three years.

There’s no guarantee Southwest’s shares can reach that goal, but if they do, a 20%-plus annualized return would beat even the stellar track record of the S&P; 500 in the five years ended last Dec. 31--a period in which the index gained an average of 18.3% a year, and many investors came to regard that kind of payoff as a birthright.

Making money off stocks is likely to be much tougher overall in this decade than in the last, for any number of reasons. If that’s true, however, it means that buying low--especially during or after panics--will be far more crucial if the ultimate goal is selling high.

*

Tom Petruno can be reached at tom.petruno@latimes.com. For recent columns on the Web, go to https://www.latimes.com/petruno.

(BEGIN TEXT OF INFOBOX / INFOGRAPHIC)

Blue Chips On Sale?

Shares of some of the nation’s biggest companies were hammered last week, with some falling to new multiyear lows. Here’s a look at how some shares have slumped:

*--*

Ticker Fri. Pctg. change: Stock symbol close Week YTD American Express AXP $25.61 --27% --53% Citigroup C 36.36 --14% --29% Enron ENE 28.30 --14% --66% General Electric GE 31.30 --21% --35% Halliburton HAL 22.58 --21% --38% Merrill Lynch MER 37.65 --20% --45% Safeway SWY 39.69 --8% --37% United Technol. UTX 42.25 --36% --46% Viacom class A VIA 31.25 --18% --34% Walt Disney DIS 17.87 --24% --38% S&P; 500 965.80 --12% --27% Nasdaq composite 1,423.19 --16% --42%

*--*

Source: Bloomberg News, Times research