Another Losing Year for the Stock Market
A strong rally since the terrorist attacks couldn’t save the U.S. stock market from recording its second consecutive losing year in 2001, a historical rarity that last occurred more than a quarter century ago.
The market’s back-to-back losses in 2000 and 2001, reflecting first the bursting of the technology bubble and then the economy’s slide into recession, may further challenge many investors’ beliefs about the long-term appeal of stocks, experts say.
The blue-chip Standard & Poor’s 500 index fell 13% last year after sliding 10% in 2000. Monday was the year’s last trading day, a session that saw the market close mixed.
The last time the S&P; index and other key indexes fell for two consecutive calendar years was 1973-74, during the first major energy-price shock and the Watergate political scandal.
Yet in true Wall Street fashion, both optimists and pessimists have seized upon the 2000-01 back-to-back losses to make their respective cases about the market’s potential performance in 2002.
The bullish case is that a third straight year of decline would be unprecedented since World War II and therefore highly unlikely, assuming the economy recovers as most analysts expect sometime this year.
The bearish case is that, despite the market’s slide since 1999, many stocks still trade at historically expensive levels relative to companies’ underlying earnings potential.
In other words, the market’s doubters say, the decline hasn’t yet wrung out enough of the exuberance that powered the market to record highs in the late ‘90s. By some historical measures, critics say, such high-profile technology stocks as Cisco Systems and Yahoo are still very expensive relative to the companies’ earnings.
Indeed, although two consecutive yearly losses are rare, Wall Street rode a record winning streak between 1995 and 1999: The S&P; 500 index, considered the benchmark performance measure for big-name stocks, produced annual returns of more than 20% in each of those years, counting price gain as well as dividends.
That spectacular run boosted many investors’ expectations for stock returns over the long term, even though Wall Street pros continually cautioned that the market’s average annual gain since the mid-1920s was about 11%, and that the late 1990s were more likely to be an anomaly than the start of a new era of much higher returns.
But by early 2000, investor optimism had reached frenzied levels amid the technology stock mania. Individual investors poured record sums into stock mutual funds in the first quarter of 2000, betting that the bull market would roar ahead.
Instead, the market overall peaked in March 2000. From its record high that month, the S&P; 500 is down 25%. The tech-dominated Nasdaq composite index has fared far worse: After losing 39.3% in 2000 and 21.1% last year, Nasdaq is off 61% from its peak--despite a powerful rebound since Sept. 21.
Yet many small investors believe the market is capable of resuming blistering gains over the long haul.
For example, a November survey sponsored by mutual fund giant Vanguard Group asked 500 participants in 401(k) retirement savings plans about their market return assumptions. The survey found that respondents expect the stock market to produce annual returns of about 7% over the next year or two. But the median expectation for long-term annualized returns was 15%.
Those high expectations raise the risk that more investors could become disheartened by another extended slide in stocks or by returns that are a shadow of what the market produced in the 1990s.
“As investors look to the future, they’ll want to be very careful about assuming that companies can resume anything like the kind of growth rates common in the late 1990s,” said Greg Smith, market strategist at Prudential Financial in New York, in a recent report to clients.
He and others say the corporate profit boom of that period was fueled by a rare confluence of events, including falling interest rates, the “peace dividend” from the end of the Cold War and the collapse of energy prices.
The stock market’s performance isn’t an abstract issue for many Americans: If the market falls for a third year in 2002 or fails to rally significantly in the next few years, it could change the financial outlook for many people, given the trillions of dollars invested in stocks in retirement plans and peoples’ assumptions about how their wealth will grow.
A weak market also could become its own worst enemy, encouraging investors to shift money to other assets, such as real estate. That’s what happened in the late 1970s: Though the S&P; index surged in 1975, blue-chip stocks’ performance in the late 1970s was relatively dismal, and many people turned away from stocks.
Today, Karen Huber and Nathan Rosenberg, married Orange County professionals, personify investors’ mixed views of stocks.
Huber, a clinical psychologist, won’t invest new money in the market now; Rosenberg won’t invest anywhere else. Although they share a household, they manage their funds separately.
Rosenberg, a management consultant, had been out of stocks for more than a year but invested all of his savings in the market Sept. 7--just a few days before the terrorist attacks. Despite taking an immediate hit, his portfolio has surged, and he’s now “solidly up,” he said. He continues to pour more money in the market, believing that the economy is on the mend.
“My sense is that the economy is going to come back fairly strongly,” he said. “I just funded my [retirement plan] today. Next week, that will all go into stocks.”
Huber, meanwhile, said she isn’t selling stocks, but she isn’t buying, either. She’s investing money she recently inherited in real estate rather than equity mutual funds.
“I just want my money to be in something that I understand and that I’ve seen work for me,” Huber said.
Wall Street’s bulls say the stock market’s surge since Sept. 21 isn’t a fluke and is foretelling an economic recovery in 2002 that should revive corporate profits and continue to drive share prices higher.
After diving the week trading reopened after the attacks, the S&P; 500 has risen nearly 19%. The Nasdaq index has surged 37%.
“Based upon the assumption that the U.S. will continue to be successful in the war on terrorism, we believe the economy could begin a significant expansion in 2002,” said William D. Witter, manager of the Enterprise Small Company Growth stock fund in New York.
A key element of the bullish case is that the Federal Reserve is expected to support stocks’ advance by keeping short-term interest rates at their current 40-year lows well into 2002.
“With a tentative economy and inflation heading lower, the Fed would have no reason to tighten credit” in the near future, Merrill Lynch & Co. economist Bruce Steinberg said recently.
With money market mutual fund accounts bearing annualized yields of less than 2%, investors will be inclined to turn to stocks as long as they believe the economy will be growing again, many pros say.
Standard & Poor’s, in its Outlook investment letter, told clients recently to expect a double-digit gain in the S&P; 500 this year and advised them to boost stocks to 65% of their total portfolio, up from a previous guideline of 60%.
But the certainty with which the majority of analysts now forecast an economic upturn in 2002 worries some Wall Street veterans.
“Almost nobody saw the recession coming [a year ago], but multitudes believe they see it going,” noted Grant’s Interest Rate Observer in its latest issue.
And even with an economic rebound, the key question for many investors is whether stock prices already reflect any corporate earnings recovery.
The average blue-chip stock still is priced at more than 20 times estimated 2002 earnings per share. That is far above the historical average of about 13.5 times earnings.
If corporate earnings turn out to be far better than expected in 2002, stocks’ price-to-earnings ratios aren’t as high as they appear. But the other way for those ratios to come down would be for stock prices to fall further.
Yet many market bulls say that, for a number of reasons, stocks deserve to sell for above-average prices relative to earnings.
“It is extremely naive to compare the P/E of stocks today to the average of the recent past,” said Edward Kerschner, investment strategist at UBS Warburg in New York. Because interest rates and inflation are far below historical norms, stocks should sell for more, he contends.
Instead of a 2002 decline, investors could see the S&P; 500 index rise as much as 37% this year, he said.
Some small investors are holding back from that kind of optimism.
Kevin Frazier, a manufacturer’s representative, said he has been selectively buying--and selling--stocks recently but has pared back his investing overall.
“I think the market is going to be weird for a while, so I’m not as active as I was,” he said.
Donald Pollock, a professor of communications at the University of La Verne, said his retirement savings got savaged in the market rout, which made him more conservative. Still, he is keeping about half his total portfolio in stocks.
“I try not to let my short-term panic get in the way of my long-term objectives,” he said. “Long term, I’m optimistic. But, during the short term, things are pretty uncertain.”
