Stock Rally Forces Investors to Reassess

Two things happened in the last 12 months.

You got one year closer to some future critical financial inflection point, such as retirement, a new business or a child’s college education.

And the U.S. stock market hit a five-year low, then mounted its biggest rally since the twilight of the late 1990s bull market.

For the many investors who all but stopped paying attention to stocks as their losses deepened from 2000 to 2002 -- it was easier just to ignore those quarterly account statements, after all -- the rebound over the last year may be bittersweet.

If you own shares, they’re probably worth more today than they were on Oct. 9, 2002, when major market indexes bottomed. The Dow Jones industrial average, at 9,674.68 on Friday, was up about 33% from its low a year ago; the Nasdaq composite, at 1,915.31, was up about 72%.

But Wall Street’s comeback has forced individual investors to again confront some of the difficult questions that came home to roost during the long bear market.

How much of your savings should be in stocks compared with other assets? What kind of returns should you expect from the market over the next decade compared with the last decade? And is now a good time to be buying -- or selling?

With the market’s losses of the last three calendar years still vivid for many people, there is a natural fear that the recovery of the last 12 months will be transitory. And who wants to suffer again the kind of pain the last bear induced?

People who bought boatloads of technology stocks in the first quarter of 2000 -- and unfortunately, there were plenty of such buyers -- may still be down 60% or more if they’ve held on, even allowing for the gains of the last year.

That’s the tyranny of the math of bear markets: If a stock drops 78% from the price you paid (that was the decline in the Nasdaq index from peak to trough), it must rise 353% just to get you back to even.

The Nasdaq index, up nearly 72% from its low of last year, would have to rise 164% from Friday’s close to regain all of the ground lost in the bear market.

But there’s another form of tyranny that follows bad markets: investors’ inability to let the past go. Dwelling on one’s losses in stocks can make it impossible to see the opportunity in the future.

There’s an old saying on Wall Street: A stock doesn’t know you own it. So you shouldn’t take it personally, whatever happens with the share price.

Exactly why the stock market has come back over the last year is anyone’s educated guess. The economy has continued to grow, stoking corporate earnings, so that’s one solid underpinning for the market. The war in Iraq was over relatively quickly, though the aftermath has been more violent than was foreseen. No other terrorist attacks have occurred on U.S. soil. And the Federal Reserve has held short-term interest rates at the lowest levels in a generation.

Also, bear markets can simply exhaust themselves -- meaning that nearly everyone who wants to sell, finally does so. At that point the bottom is reached.

As first-year rebounds go from bear-market bottoms, this one has been less robust than the rebounds from three of the last four bear lows.

Tracking the Standard & Poor’s 500 index, it’s up 33.6% from its low on Oct. 9, 2002. By contrast, the first-year rebound from the bear market that ended in 1970 was 43.7%. The comparable numbers were 38% for 1974-75, 58.3% for 1982-83 and 29.1% for 1990-91.

Many market bulls say the comparisons suggest that this rally has further to run.

What’s different this time, however, is that stocks already are selling for historically above-average prices relative to per-share earnings.

Depending on whose estimates you believe, the price-to-earnings ratio of the S&P; 500 index is between 18 and 21 based on expected 2003 operating earnings, meaning profit before one-time gains or losses.

Analysts who are downbeat on stocks say the valuation issue argues against the idea that the market is poised to rocket from here. Likewise, they say, there are too many signs of wild speculation in stocks, akin to what was going on early in 2000.

Case in point: the recent heavy trading in the mostly small-company shares that dominate the over-the-counter Bulletin Board market.

“To put it as bluntly as possible, bull markets do not begin at high valuations, in the midst of speculative bubbles, with a majority of [financial] advisors looking for higher prices,” said John Bollinger, a veteran analyst and editor of the Capital Growth Letter in Manhattan Beach.

His view is that a sell-off is looming -- a “correction” that typically would be expected to cut 10% to 15% off the average stock’s price. After that, the market may rally again in 2004, Bollinger allows. But longer term, he believes that stock prices overall are condemned to a back-and-forth trading pattern that may produce little net profit for buy-and-hold investors.

It’s a very popular view on Wall Street, in large part because it seems to make sense that the greatest bull market in history (the 1982-2000 period) would be followed by something more like the 1966-1982 period, which was a trading-range market, at least for blue-chip stocks.

But there are other pros who say that the argument for a go-nowhere market in the long run is too simple, and obscures the potential to earn hefty stock gains when the bulls are running.

James Stack, editor of the InvestTech Market Analyst newsletter in Whitefish, Mont., became increasingly bearish on stocks as they rocketed in the late 1990s. But he sees a much different market today.

“This is the best value-hunting environment that we have had in a decade,” Stack said.

The breadth of the rally over the last year is a telling sign that the rebound is for real and isn’t likely to fizzle soon, he said. It’s supported by rising corporate earnings and low interest rates, which is classic, he noted.

Will there be another bear market? Of course, Stack said. In fact, he figures they will occur with more regularity in the next decade or two. But that isn’t a good reason to stay out of stocks now, he said.

If the S&P; 500 rises just 5% next year, that may still be more than five times what an investor would earn by leaving cash in a money market fund.

And what if, looking out 10 years, the trading-range stock market view turns out to be wrong? If you can earn 5% a year in stocks over that period (which would be about half the historic average), that still might far exceed what you’d earn in safe short-term accounts.

That’s an important consideration when you factor in your long-term financial goals. If you can’t get there based on what you can earn in risk-less accounts, then taking some risk -- in stocks or other potentially higher-return investments -- becomes a virtual necessity.

How much risk? That’s a personal decision. But when you are judging risk in stocks, keep in mind that the market is an awfully big place. With diversification among the major classes of stocks (large, small, growth, value, foreign, etc.) you can lower your overall risk.

In the five years ended Sept. 30, for example, it’s worth noting that while the big-stock S&P; 500 index produced an average annual total return of just 1%, the small-stock Russell 2,000 index return was 7.6% per year.

For investors who figure they probably need more stocks in their portfolio rather than fewer, but are frozen in place, Stack has two bits of advice.

First, don’t think about the market as an “all or nothing” proposition, he said. Make incremental moves -- put some money to work now, and buy more over the next year.

Second, remember that if you try to wait until you feel absolutely comfortable with the stock market, “I can guarantee that that will be when the market is at a top,” Stack said.

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Tom Petruno can be reached at tom.petruno@latimes.com.