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Can the bull still run?
A return to normalcy, not a bear market, may lie ahead

By Steven Butler

Investors may be wondering whatever happened to that "new economy," the world in which technology breakthroughs, high levels of investment and employment, soaring productivity, and low inflation were supposed to keep the stock market bubbling along forever. Last week's modest bounce in stock prices was at best a weak bromide needed after this year's stomach-churning roller coaster ride down Wall Street. The 500 big-capitalization stocks that make up the Standard & Poor's composite index have so far lost about 6 percent of their money this year. And they are the lucky ones. Beaten-down technology stocks have dragged the once highflying Nasdaq index down by about 20 percent.

In fact, the new economy is alive and well. Not so the great bull market of the 1990s.

"Great" is the key word. "The great bull market will be followed by the not-so-great bull market," predicts Edward Yardeni, chief investment strategist at Deutsche Banc Securities. "We still have a bull market ahead of us, but not the kind of returns we have seen over the past five years."

Yardeni is an optimist. Robert Shiller, the Yale economist who wrote Irrational Exuberance, expects a huge payback for the market excesses of the 1990s, including possibly a 50 percent tumble in stock prices. "I don't know if I can quite believe that will happen," Shiller admits. "But the returns on stocks are quite plausibly negative on average for the next 10 years."

Of course, stock market predictions are famously inexact. Yet the past five years were extremely unusual, and the economic conditions that fueled the market boom are most likely unrepeatable. Indeed, the five years from 1995 to 1999 were the best ever for stocks. The S&P 500 returned an average of 28.7 percent a year, easily beating any comparable period dating to 1926, when the venerable index was created. Even more impressive: Each of the five years returned more than 20 percent. Never before had the S&P 500 turned in more than two consecutive years of 20 percent-plus returns. Nasdaq investors did even better, getting roughly 40 percent annual returns.

"The stars and the planets all lined up just right over the past few years," says Yardeni. Now, despite the continuing strong economy, many of the celestial bodies are drifting out of alignment. Just how the macroeconomics change could determine whether the years ahead are a pale copy of the immediate past or more like the market disaster Shiller envisions. The most important factors:

Interest rates. Many analysts date the bull market to 1982, when yields on the 10-year Treasury bond hovered around 13 percent and the ratio of stock prices to earnings per share on the S&P 500 hit 7.56. As inflation gradually receded, interest rates also declined to below 6 percent, which had the effect of making an uncertain stream of corporate earnings relatively more attractive. Rather than paying $7.56 for $1 of annual earnings in 1982, investors at the end of last year were paying $33.29. Stock prices skyrocketed not just because corporate profits were growing but because investors were willing to pay over four times as much for those earnings. A company that doubled its earnings, for example, might see its stock price leap by over eight times during the period.

Unfortunately, the fall in interest rates and the accompanying rise in price-to-earnings ratios may have reached a limit. Douglas Cliggott, equity strategist at J. P. Morgan, points out that the 10-year interest rate fell over 25 percent, from 8 percent to below 6 percent, from the end of 1994 to last year. "Over the next five or seven years, do we really expect bond yields to fall another 25 percent, by 1.5 percentage points? I think the answer is no because the underlying trend in inflation is probably flat," he says. That means that stock market returns, over the period, would very likely reflect only actual earnings growth and not a price multiplied by the dropping interest rate. Jeremy Siegel, the Wharton School professor who wrote Stocks for the Long Run, makes the same point. The average P/E ratio for the S&P 500 has now fallen back to around 25. Siegel believes low inflation and good management by the Federal Reserve warrant a P/E ratio well above the historic average of 15 but possibly below today's level. Any further fall in the P/E ratio, of course, means a big drag on stock prices even if profits leap ahead.

Earnings. The last years of the millennium were good for corporate profits. Operating earnings per share on the S&P 500 grew an average of 10.2 percent a year, nearly twice the rate of economic growth (which was 5.56 percent unadjusted for inflation). That meant that corporations claimed a growing share of America's economic pie, a trend that most economists believe can't continue indefinitely. "I'm not sure you can assume that profit margins go up forever, because the flip side of that is that working people have to accept a smaller share of the pie year in and year out," says Cliggott. In a tight labor market, that seems unlikely. Cliggott expects profit growth to average 5 percent to 8 percent a year, which is about how he expects the stock market to perform. Siegel, however, believes there is room for faster growth. That's because total business earnings–including unincorporated businesses such as lawyers and proprietors–are still below the long-term average as a share of economic output.

Money supply. Rapid growth of the money supply in the late 1990s provided raw fuel to the market. Monetary easing began shortly after the Asian financial crisis triggered by the collapse of the Thai baht in July 1997. It continued with the Russian financial crisis and the collapse of Long-Term Capital Management in October 1998. In 1999, the Federal Reserve again flooded the economy with money as it prepared for possible disruption from the Y2K computer bug. But the Fed reversed course quickly, and the monetary base is now 2 percent smaller than last December. That extra money sloshing through the system made it easy to borrow money to buy stocks along with everything else, like houses, cars, and vacations.

Energy prices. Even the new economy needs energy, which was extremely cheap after the Asia crisis broke and oil fell below $10 a barrel. Today, oil, natural gas, and electricity prices have soared, and energy supplies may be tight for years. "Energy prices go in cycles, but we are not seeing the rush of spending to expand capacity we have seen in other cycles because people have been burned in the past," says Daniel Yergin, president of Cambridge Energy Research Associates. Many companies in basic industry have trouble passing along higher energy costs to consumers and so find their profits squeezed.

Productivity. The increase in the rate of productivity growth from roughly 1.4 to 2.6 percent a year was the miracle of the 1990s that allowed the economy to race ahead without causing inflation. Many economists believe the economy can continue growing at 4 percent to 4.5 percent a year. Yet, for the most part, high productivity and economic growth are already factored into stock prices, says Cliggott. Hardly anyone believes that further increases in productivity growth are in the cards, and, in any case, corporations may not benefit. "The gains from productivity will go to the consumer because of competition. It is just a temporary feature that the corporations get all the gains," says Siegel. Future competition will likely pare down profits while consumers will get a better deal.

The dollar. Betting against the dollar has been a losing proposition for many years. Still, with the United States running a record trade deficit and with other countries adopting the productivity-enhancing technology that boosted the U.S. economy, few believe the dollar can do better than just hold its own in the future. That gives foreigners one less incentive to buy U.S. stocks, since they won't get a bonus return on a strengthening dollar, and it means one less factor holding down inflation, since the rising dollar reduces import prices.

Washington ungridlocked. "Gridlock has been very good for the stock market," says Yardeni. That started in 1994 when the Republicans took control of Congress, halting grand political initiatives that investors did not want. No matter who wins next week's election, politicians bent on reshaping America's tax and Social Security systems will come to office. It could easily unsettle Wall Street.

Exuberance. Perhaps the biggest unknown is how the investing public would react to the prospect of lower stock market returns, possibly including a few years of outright losses. Shiller documents a clear historical pattern in which high price-earnings ratios are followed by years of lower returns or losses. That kind of performance could easily unravel the psychological underpinnings that Shiller says have supported unrealistically high prices, and cause a rush to the exits.

Siegel thinks that investors should take another look at boring bonds, which historically have beaten stocks in 2 out of 5 years. Cliggott agrees: "There is no doubt that looking backward it was best to have the vast majority of your assets in U.S. equities. What you might want to think about in the next five to 10 years is a more diversified portfolio." Already, this year, government bonds have trounced the stock market. Who knows? Old-style investment saws–like spreading exposure to reduce risk or buying cheap stocks rather than chasing growth–may even become fashionable again.

-- (M@rket.trends), November 01, 2000

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