Investors Facing New Landscape

Investors thinking about how to save or invest a spare dime these days may quickly come to believe they are severely short of decent options.

To many people it probably feels too late to buy stocks, with major market indexes up 20% to 30% since mid-March. The blue-chip Standard & Poor’s 500 index rose again last week, the ninth advance in 10 weeks.

It feels way too early to buy high-quality bonds such as Treasury issues, as yields hover near 45-year lows.

Meanwhile, money market funds and short-term bank CDs may offer peace of mind about one’s principal, but little more. And yields on those accounts, typically below 1%, may fall further this week if the Federal Reserve cuts its key rate, as expected.

Residential real estate? In Southern California, good luck finding something to buy.

There is a reasonable argument that investors are dealing with the same old, same old. It’s rarely easy to make decisions involving markets; clarity is available only in hindsight.

Still, the struggle that investors face in choosing the “right” financial path today is compounded by some of the new realities of markets and the economy -- major changes that have taken place over the last year or so that altered the investing landscape, possibly for a long time to come.

In that sense, there is a re-education process that goes along with making money decisions now.

The biggest change possibly has been in the outlook for inflation. For the last 23 years, even as the rate of inflation has declined, investors have been conditioned to believe that a resurgence in prices was ever-imminent.

But this year, inflation lost its status as Public Enemy No. 1. Instead, the Federal Reserve and others began to warn that the weak global economy was fostering a greater risk of deflation -- a broad-based decline in consumer prices.

Whether the United States is at risk of deflation is far from certain. Last week, the government said its index of consumer prices was unchanged in May after declining 0.3% in April. The so-called core rate of inflation (excluding food and energy prices) rose 0.3% in May, the biggest increase since August.

Even so, there is no question that overall inflation, at least as measured by the government, remains very low. The core consumer price index has risen at a rate of 1.6% in the last year. Remember when 3% was considered the minimum annual U.S. inflation assumption?

The risk of deflation, however modest, is expected to spur the Fed to cut its benchmark short-term rate (now 1.25%) when policymakers meet this week.

Many analysts believe the only question facing the Fed is the size of the cut -- whether it will be a quarter point or a half point.

Low Rates to Stay

Wall Street has read into the Fed’s deflation talk of the last few months a simple but powerful message: The central bank is going to keep short-term interest rates depressed for an extended period, probably well into 2004, to try to ensure that the economy recovers.

And if short-term rates are to stay low, they will be expected to exert a strong downward pull on longer-term rates as well. That’s what has driven bond yields down this spring. The yield on the bellwether 10-year Treasury note ended at 3.36% on Friday. That was up from the 45-year low of 3.11% reached a week earlier, but still sharply lower than the 3.96% level of late January.

As always, there are three possibilities for interest rates: They could fall further; they could stay level; or they could rise.

Many market professionals believe the Fed is serious about keeping short-term rates down. That almost ensures that investors have no hope of better returns anytime soon on money market funds and other short-term accounts.

What about bonds? The Fed doesn’t directly control long-term interest rates. But it has hinted in the last seven months that it could try to directly influence long-term rates by using its own capital to buy bonds in the marketplace.

Short of that, however, many market pros, like many individual investors, believe that it’s a bad bet to lock in current long-term yields, at least on Treasury issues. If the economy shows even slight improvement in the second half of the year, the assumption is that long-term yields will have to rise from today’s levels, meaning investors will have a better entry point later if it’s bonds they want.

“The biggest trade of the next couple of years is likely to be shorting the bond market,” says John Bollinger, editor of the Capital Growth Letter in Manhattan Beach. “The odds are very strong that we will see a substantial increase in interest rates.”

Given the number of speculators believed to be operating in the bond market, yields could whiplash significantly in a short time. We’ve seen that happen several times since mid-2000, even as the general trend has been down.

Yet there is widespread disagreement about how high bond yields would stay even if the economy picked up speed. If inflation stays relatively low amid cutthroat corporate competition to sell goods and services, there is a strong argument that bond yields could remain mostly in a range that would be far below the level investors remember from the 1980s and 1990s.

David Rosenberg, economist at Merrill Lynch & Co. in New York, studied the history of U.S. interest rates and found that the yield on long-term government bonds was in the range of 1.5% to 3.5% almost three-quarters of the time from 1875 to 1955.

The lesson, he said, is that “reverting to the mean [in terms of yields] may well mean something other than moving back to last year’s levels.” In extended periods of low inflation, investors have accepted lower bond yields as well, which makes sense.

Let’s say the optimists are right, and the landscape for interest rates over this decade will look very different from the landscape of the 1990s. Where would that leave the stock market?

One classic stock valuation model converts the yield on the 10-year Treasury note to a price-to-earnings ratio, to compare with stocks. With the 10-year note yield at 3.36%, the note’s P/E is about 30.

By contrast, Standard & Poor’s says the average stock in its universe of 1,500 major U.S. companies is priced at about 18 times estimated operating earnings over the next 12 months.

Investors who fear that this year’s rally has been overdone might gain some comfort comparing current P/Es with those in December 2001, at the height of the market rally that followed the Sept. 11 terrorist attacks. The average P/E then was 22. So the market appears to be cheaper now than it was then, and interest rates are lower.

Many Wall Street bulls say stocks deserve their current prices, or better, even if interest rates rebound. Historically it hasn’t been unusual for the market to advance even as rates have risen, at least in the early stages of economic recoveries.

Edward Yardeni, investment strategist at Prudential Securities in New York, figures the average stock P/E could be 20 by the end of the year, assuming the economy revives. That could mean an additional 10% to 15% gain in share prices by year’s end, he said.

In other words, investors who worry that it’s too late to buy stocks are being overly cautious, Yardeni suggests.

Bullish Assumptions

But there are many assumptions built into the bullish case. Interest rates must not rocket and stay high; ditto for inflation; and corporate earnings must continue to improve.

Sung Won Sohn, economist at Wells Fargo & Co. in Minneapolis, isn’t as sanguine as Yardeni. He fears that stocks already may have reached the best levels investors can expect if the economy revives and pulls interest rates up. He expects the 10-year T-note yield to hit 4.9% next year.

“A sustained bull market is not a sure thing,” Sohn warns. “This could be another bear market rally.”

Even if an investor believes the optimistic case, stock prices have had a phenomenal run since mid-March. The Dow Jones industrial average, at 9,200.75 on Friday, is up 10.3% year-to-date. The technology-dominated Nasdaq composite is up 23.2%.

In a bull market -- if that’s what this is -- prices pull back periodically. The question isn’t if, just when.

“We know that at some point, we are going to have a ‘correction,’ ” says an otherwise bullish Steve Todd, editor of the Todd Market Forecast newsletter in Mission Viejo. “It’s like the common cold. You know you’re going to catch it from time to time.”

A correction may be just what many sidelined investors are hoping for. The challenge will be for them to step up and buy when it occurs. It’s never as easy to do when the time comes.

At a minimum, what investors have learned from the last three months is that the appetite for stocks can recover very strongly and very quickly. Whether this rally has staying power, it should be clear by now that when pessimism is at its peak -- as it was last July, again in October and again in mid-March -- buying opportunities in the equity market abound.

If we aren’t entitled to a wild bull market in this decade, we may at least be permitted some highly profitable rallies from time to time. That’s better than nothing.

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