Last Straw for Small Investors?

The stock market peaked 27 months ago, and with every new decline since then the same question has been asked about individual investors: How much can they lose before they can stand to lose no more?

For some Americans whose trillions of dollars in savings helped drive the great 1990s bull market, the threshold of pain may finally have been crossed.

Bob Friend, a Redondo Beach aerospace engineer who has invested in stocks for 20 years, says he plans to move more of his investments into interest-bearing bonds, or perhaps gold, in the next month.

Stung by his portfolio losses and disheartened by mounting revelations of corporate fraud--the latest WorldCom Inc.’s bombshell last week of $3.9 billion in accounting irregularities--Friend says his faith in the market has waned.

“There’s a complete lack of trust in corporate leadership,” he said. “I think the lack of ethical behavior has destroyed investor confidence.”

Comments like those are sending a chill through Wall Street. Individual investors were a big source of fuel for the stock market’s unprecedented gains in the 1990s, a decade in which the total value of the 5,000 largest U.S. stocks soared from $3.4 trillion to $14 trillion--a wealth boom that, in turn, helped power the economy.

Perhaps more important, the public’s willingness to largely stay in the market through the devastating decline of the last two years may have kept stocks’ losses from becoming far worse.

Now, some analysts fear that many small investors are on the verge of giving up on the market.

“The new concern is that we have lost a generation of individual investors, much the way we did after the Great Crash” of 1929, said Edward Yardeni, market strategist at brokerage Prudential Financial in New York.

Souring on Stocks

Investors also soured on stocks en masse in the 1970s, after the market plunge of 1973-74. Measured from 1972 to 1981, the net gain in the blue-chip Standard & Poor’s 500 index was a minuscule 3.8% as investors stayed away.

The worries about another lost generation of investors may yet prove to be overblown. What’s more, even if Americans have had their fill of stocks, it isn’t clear that the implications would be dire. The economy doubtless would survive without a rising stock market. Savings that might have been earmarked for equities would simply flow elsewhere--into banks, for example, or the real estate market.

The housing market, red hot this year while stocks have fallen, already appears to be luring money that might otherwise have gone to Wall Street.

But an equity market that stalls out, or declines further, could make it far more difficult for U.S. companies to raise capital needed to grow. Likewise, poor returns in the stock market would change the financial outlook for the tens of millions of people whose retirement nest eggs still are locked up in stocks.

Even now, many older Americans must rethink their retirement spending plans as share prices have tumbled. The S&P; 500 has dropped 35% from its record high in March 2000. That is the deepest sustained decline in the index since it dived 48% in 1973-74 amid the Arab oil embargo, surging inflation and President Nixon’s resignation.

An investor whose retirement portfolio has tracked the S&P; 500, and who had $500,000 at the market peak in 2000, has $325,000 now.

More exasperating for investors has been the duration of this slide and the volatility along the way. Twice in the last 15 months, stocks staged sharp rallies that appeared to mark the end of the bear market. Instead, the rallies quickly gave way to renewed downturns.

The S&P; 500 hit a three-year low on Sept. 21 in the aftermath of the terrorist attacks. The market then rocketed in the fourth quarter as investors bet that the U.S. military would prevail in Afghanistan and that the economy would soon emerge from recession--both correct bets, as it turned out.

But as 2002 dawned, many stocks crumbled anew. And last week, long-distance titan WorldCom’s revelation that it understated expenses by $3.9 billion over the last five quarters, effectively hiding a sea of red ink behind phony profit statements, triggered a wave of selling that drove the S&P; index briefly below its close on Sept. 21.

There are various ways to measure “bull” and “bear” market cycles. But if the S&P; 500’s dip last week below the September low means the bear market didn’t end after the terrorist attacks, it is now 27 months old. For the S&P; index, that would be the longest decline since the 1940s.

A Third Year in the Red

The harsh financial reality for many buy-and-hold investors is that their portfolios are deep in the red for a third straight year--a rarity in modern market history. If the trend holds through December, this will be the first time the market has fallen three consecutive calendar years since 1939-41.

Investors in the giant Fidelity Magellan stock mutual fund, for example, lost 9.3% in 2000, 11.7% in 2001 and are down 14.6% this year.

The erosion of stock values has left more investors mulling Will Rogers’ famous line about investing: “I am not so much concerned with the return on capital as I am with the return of capital.”

So far this year, Americans have pumped $203 billion into regular savings accounts at banks and savings and loans, Federal Reserve data show. By contrast, through May net new purchases of stock mutual funds totaled $72 billion, according to the funds’ chief trade group.

That is a dramatic shift from years past. In 2000, stock mutual funds attracted $310 billion in new money while savings accounts took in $142 billion.

At Charles Schwab Corp., the nation’s largest discount brokerage, customer trading volumes have dropped more than 25% in two years as interest in the market has ebbed.

Bryan Carichner, a 27-year-old Web site developer in Los Angeles, says he is keeping all of his savings in a money market account, even though interest rates on those accounts are typically less than 1.5%.

“I feel that it’s safer,” Carichner said. “When I first got out of college, the stock market seemed like an amazing place to supplement your income and get ahead very quickly. Now I think you really need to know what you’re doing, whereas before it seemed you could just throw anything against the wall and something was going to stick.”

Certainly, by now most Americans know some of the fundamental reasons the 1990s bull market died: The economy had peaked after a stellar 10-year expansion; the Federal Reserve had raised interest rates to counter what it believed were inflation threats; and, perhaps most significant, technology stocks had begun to implode after being driven to stratospheric price levels by rampant speculation rooted in the popular mania over the Internet.

Just as technology shares enjoyed incredible gains in the late 1990s, they have borne the brunt of the market’s losses since March 2000. The tech-dominated Nasdaq composite stock index peaked at 5,048.62 in that month. It now stands at 1,463.21, down 71% from the peak, as once-star stocks such as those of Intel Corp., Cisco Systems Inc. and Sun Microsystems Inc. have collapsed.

That loss rivals the near-90% decline in the Dow Jones industrial average between 1929 and 1932.

Unlike the early 1930s, however, this bear market hasn’t coincided with an economic depression. Indeed, the 2001 recession was one of the mildest on record, as measured by the decline in gross domestic product. Consumer spending has remained surprisingly strong, especially on autos and homes.

But for many U.S. companies the recession’s effect on profits was crushing, amid high debt loads, rising foreign competition and a downturn in spending by other businesses, particularly on tech equipment.

At the start of this year, worries about companies’ earnings remained the market’s most vexing problem, as investors questioned how long it would take for profits to get back on a growth track. Earnings, after all, are what ultimately drive stock prices.

Fear of more terrorist attacks also has weighed on investors’ confidence, since stocks represent a bet on future prosperity.

Increasingly, however, blame for the market’s ongoing decline has been laid at corporate America’s door: The succession of accounting scandals and tales of executive chicanery--from Enron Corp. to WorldCom--have left investors angry and disgusted.

The revelation by WorldCom, parent of the MCI long-distance network, drilled deep into a public nerve. “It makes people lose faith in the system,” said Allan Spring, a 45-year-old computer programmer in Irwindale.

Ron Kahn, head of a $65-billion stock portfolio at Barclays Global Investors in San Francisco, said investors’ collective doubt about the trustworthiness of corporate financial data “is much more serious than [the issue of] a lot of stocks that were overvalued coming back to fair value.”

The accounting scandals “are what could drive individual investors out of the market,” he said.

Concerned With Timing

Yet instinctively, some small investors sense that bailing out of stocks at a time of crisis is a foolish move. Spring said he is tempted to shift his money into bonds, gold or money market accounts, “but then this other side of me says that once I do that, [stocks] will turn around.”

Some market experts say that while the corporate scandals may chip further at investors’ confidence, the public’s turn away from stocks had already become self-reinforcing.

In his April 2000 book “Irrational Exuberance,” Yale University economics professor Robert Shiller described the late-1990s bull market as a spectacular financial bubble that would inevitably be followed by a long period of lousy returns on stocks.

Just as investors’ bullish behavior fed on itself as stocks rocketed from 1995 to early 2000, so too their pessimism would feed on itself once the market began to slide, Shiller wrote.

Many investors, he said, will become far more interested in preserving whatever capital they have left. That could become an acute concern for the ranks of near-retirees who plan to start tapping their savings in a few years.

In an interview last week, Shiller said he is not optimistic about a market rebound and that he sees no reason to change his view that buy-and-hold investors in U.S. blue-chip stocks will earn no net return through the end of this decade.

That was a heretical view in 2000, but “I’m not so unique anymore,” Shiller said. “As the market goes down, all kinds of theories that didn’t seem plausible begin to look more plausible.”

The fundamental problem, he said, is that the average big-name stock still is overvalued by historical standards.

A common way to measure a stock’s relative value is to compare the price with the company’s earnings per share, excluding one-time charges. Based on Wall Street’s average earnings expectations, the S&P; 500 index is priced at about 20 times this year’s estimated earnings per share.

But the historical average price-to-earnings ratio for blue-chip shares is about 14, Shiller said. For the market just to be valued at average levels, then, the S&P; 500 index should be 30% below its current value.

Yet many experts say there are good reasons for above-average prices on stocks, and good reasons to expect investors to stay in the market, unlike after the plunge of 1973-74.

What’s different from the late 1970s is that the U.S. economy enjoys low inflation, high worker productivity and low capital-gains taxes, said Jay Mueller, economist at Strong Capital Management in Milwaukee.

All of those factors benefit the stock market, he said. In addition, stock investing is automatic for millions of investors today, via retirement savings plans. People tend to be slow to make changes in how they allocate those dollars, and there is no sign this year of any wholesale selling of stocks in retirement accounts.

But investor surveys, and anecdotal evidence, suggest more investors are growing wary. And in a weak market, even a small number of new sellers can tip the scales, driving prices lower.

U.S. Trust Co., which periodically surveys wealthy households (defined as those with annual gross income of $300,000 or more, or net worth greater than $3.75 million), in June found that 25% of 150 respondents said they have sold off some or all of their stocks since March 2000. But the majority--52%--said they are “waiting to see what happens.”

‘I’m Not Giving Up’

For many individual investors, the decision so far has been to halt new purchases of stocks, while holding on to what they have.

“I’m not giving up on stocks, but I’m putting my money into more liquid, more secure investments until I feel the storm has passed,” said investor Alton Pabom, an auditor in Los Angeles.

Still, he said, “I know it [the market] is coming back for sure. The U.S. economy is very resilient. I still maintain the optimism that it will bounce back, so I’m not selling.”

Wei Chi, manager of global diversity for oil company BP North America, said he isn’t planning to invest any additional money in the stock market for the next three to six months. “Now, it’s just wait and see if the crisis is resolved,” he said, referring to the corporate accounting scandals. But he continues to hold on to stock investments meant to finance his children’s college education.

Chi, 49, worries more about the scandals’ effect on younger people’s view of the market as a long-term investment. “For the younger investors, it’s very discouraging. It may actually scare them away for a long time,” he said.