Investors Struggle During a Time of No Returns

This is becoming the year of no returns in financial markets.

The blue-chip Standard & Poor’s 500 stock index’s return is exactly flat year-to-date, counting dividend income.

The average domestic stock mutual fund is down 1%, according to Morningstar Inc.

The Pimco Total Return fund, the nation’s biggest bond mutual fund, is up a mere 1.2% this year. You’ve earned even less than that in the typical money market fund.

Gold? It’s down 6% this year.

No wonder people still are paying ridiculous prices for residential real estate. There doesn’t seem to be much incentive to look anywhere else.

“A slough of despond” is how Wall Street veteran Jeffrey Applegate, chief investment officer at Fiduciary Trust Co. International in New York, characterized the stock market’s mood in July -- a month in which the S&P; 500 dropped 3.4% in price and the Nasdaq composite index slid 7.8%.

When strategists like Applegate start quoting from “The Pilgrim’s Progress,” you know it’s a tough market.

This could turn out to be helpful training for the patience-challenged, however. There’s a school of thought that says annualized returns on financial assets, in general, will average in the low to mid single digits for many years to come.

An annual return of even 5% begins to look generous after a market environment like this year’s.

For many investors, the knee-jerk reaction to the idea of single-digit gains might be to give up on markets altogether. But that would be an extreme move, and probably would turn out to be a mistake for most people who still consider themselves to be long-term investors.

Any investment return, after all, has to be judged in the context of the alternatives.

For the moment, there’s another perspective on the stock market’s lousy performance: Maybe it’s surprising that equities haven’t fared worse, given what they’ve faced over the last five weeks.

The U.S. economy unquestionably has slowed, as the government’s report Friday on second-quarter gross domestic product showed. GDP rose at a real annualized rate of 3% in the quarter, down from 4.5% in the first quarter.

Yet there’s no sign that the Federal Reserve will put off further interest-rate hikes. The next Fed meeting is Aug. 10.

Meanwhile, oil reached $43.80 a barrel Friday, a record price, at least before adjusting for inflation.

And there seems to be a new terrorism warning every week.

“There’s no compelling reason to buy stocks,” said Robert Mikkelsen, a longtime trader at brokerage Advest Inc. in New York. At the same time, he said, “People also don’t feel an urgency to sell.”

Still, the news has been disheartening enough to cause some of the market’s biggest optimists to curb their enthusiasm.

Standard & Poor’s investment policy committee last week reduced its year-end target for the S&P; 500 index to 1,150 from 1,210.

Also last week, Edward Yardeni, investment strategist at Prudential Equity Group in New York, cut his year-end target for the S&P; 500 to 1,190 from 1,300.

If it finishes the year at 1,150, the S&P;’s price gain for the 12 months would be 3.4%. At 1,190 it would be up 7%. Add about 1.7 percentage points for dividend income for the potential total return.

Anyone’s market forecast is an educated guess, at best, but it can be a useful reality check for average investors to think about where the economy might be headed and how markets might respond.

For example, if you assume that the economy will continue to grow over the next year, and that corporate profits will grow as well -- albeit at a slower pace than in recent quarters -- that could provide a solid underpinning for the stock market.

At the same time, a growing economy probably would mean that the Federal Reserve would continue to raise its benchmark short-term interest rate, which the central bank boosted from 1% to 1.25% on June 30.

If the Fed lifts its rate a quarter of a percentage point at every meeting between now and next July (a strong possibility, many economists say), it would stand at 3.25% a year from now.

So that provides a ballpark idea of what money-market accounts and other cash accounts might be paying in a year.

As for high-quality bonds, such as Treasury issues, yields on those securities already have moved up this year, anticipating that the Fed would begin to tighten credit. The yield on the 10-year Treasury note ended Friday at 4.47%.

Many bond market pros believe that long-term interest rates will go higher as the Fed pushes short-term rates up. But anyone waiting for double-digit yields is likely to be disappointed, barring some global economic calamity.

Jack Malvey, chief global fixed-income strategist at brokerage Lehman Bros. in New York, figures that the 10-year T-note yield might reach between 5.5% and 6% by the end of 2005, if the economy stays on a growth track but inflation doesn’t soar.

Could the stock market advance if bond yields got that high? Bonds certainly would provide more competition for stocks. But it wouldn’t be the level of competition of the 1980s and 1990s, when the 10-year T-note yield mostly was above 6%.

If interest rates aren’t going dramatically higher in the next few years, one way to think about the stock market’s potential is that it doesn’t have to rise a lot to beat the main alternatives.

And there are plenty of pessimists who believe stocks shouldn’t rise a lot -- even though the market has plenty of catching up to do by 2009 just to produce a decent average annual return for the decade.

Why should stocks’ performance be restrained? Despite the long bear market from 2000 through 2002, share prices, on average, never got as cheap relative to earnings per share as in previous bear markets.

The S&P; 500 index now is priced at about 16 times estimated earnings over the next 12 months, according to S&P;’s own estimates. Many market veterans don’t consider that to be an expensive price-to-earnings ratio, but neither do most consider it to be a real bargain.

If it’s a middle-of-the-road valuation, then the best-case scenario for broad indexes like the S&P; 500 might be middling returns for quite some time -- particularly in the face of higher interest rates and the ever-present terrorism threat.

People are fearful of what might go seriously wrong in the world, so they want to limit the risks they’re taking with their money. That means they don’t want to overpay for stocks. It makes sense.

But it’s a big equity market (and a global one). Some shares are bound to do better than the indexes, and some much worse. For long-term investors to give up on equities completely at this point would be to cave in to the depressed sentiment of the moment, and to totally discount what might go right.

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