SOCIAL TOPICS (Archive): INVESTMENT & ECONOMIC ANALYSIS  

Published, Fall 2002

The 17.6 percent decline in the U.S. stock market in the third quarter brought the year-to-date loss to 28.2 percent, an amount greater than any calendar year loss since 1937. This year’s decline follows losses of 9 and 12 percent in 2000 and 2001, making the last three years the worst three-year period in the stock market since the Depression. For some time now, the paramount questions for investors have been: Why is this happening? Are we at the bottom? Or, should we move assets into bonds?

The Technology Bubble

Among several reasons for the market decline, the most well known is the correction of the extreme overvaluation that had developed from 1995 to 1999. The market (as measured by the S&P 500) had an average annual return of 28.5 percent for the five years ending in 1999, by far the highest five-year return the stock market has ever recorded. These returns were achieved with an average annual earnings growth rate of 9 percent and an increase in the market’s price/earnings ratio (the measure by which those earnings were valued) from 14 to 29 times - led by even more dramatic changes for the S&P 500 technology sector.

Through early 2000, the economy was thought to be in a virtuous cycle of strong growth, low inflation, and rapid productivity gains. The technology sector, previously considered to be made up of manufacturers and providers of capital goods subject to cyclical forces, was thought to have entered a new era of continuous growth, as investment in the Internet would continue uninterrupted well into the future. But capital spending on technology slowed, then virtually stopped, and the economy entered a recession in March 2001. The high p/e ratios in the market required strong earnings growth; those in technology required astronomical growth. Stalled or declining earnings resulted in falling stock prices. In 2000 and 2001, stock price declines were confined pretty much to technology and related sectors, while the rest of the market held up fairly well.

The Economy’s Impact

The mild 2001 recession was a second factor in the continuing market decline. The recession was limited, as low interest rates maintained by the Fed kept the housing and auto markets fairly strong. More recently, while employment remains reasonably healthy, consumer spending has moderated - and with it overall GDP growth - to the point where employment gains and a strong recovery in corporate profits are unlikely near-term. The risk that the economy may slip back into recession has increased over the past several months, and this unease has weighed heavily on the market.

Fraud and Abuses Revealed

With the valuation adjustment essentially complete, and coincident with early signs that the economic recovery was faltering, news of corporate fraud and extraordinary abuses by managers at Enron, Arthur Andersen, WorldCom, Tyco, and elsewhere contributed to a growing lack of confidence in the financial markets. Since then, earnings of company after company have come into question amid revelations of special accounting items, unrealistic pension assumptions, and misleading option accounting. As a result, this year’s market decline has been felt well beyond the technology and related sectors. While we are seeing examples of swift enforcement and are reassured by much-needed legislative, regulatory, and corporate governance changes, it may take time and continuing progress on these issues for the stock market to recover.

September 11 Changed the World

Now that we have passed the anniversary of the terrorist attacks, the real and possible effects beyond the absolute shock of the events themselves are coming into focus. Consumer spending behavior has changed; how enduring this will be we don’t know. The airline, hotel, and restaurant industries are feeling the impact of reduced travel. The impact of added security costs is being felt well beyond the airline industry, as a visit to almost any office building will demonstrate. The cost of fighting the war on terrorism is already visible in the federal budget. The possibility of war with Iraq underscores the risk that deficit spending may lead to inflation in the next few years.

Have We Reached Bottom?

We all know there isn’t an easy answer. The possibility of further terrorism, compounded by the threat of a war, is surely a factor in the market’s current volatility. What keeps us from being more aggressive buyers of stock just yet, however, is the real possibility that currently languid GDP growth will prove insufficient to support the corporate profit recovery necessary to turn this market around; we may well see further near-term declines.

Yet, equity valuations based on corporate earnings power are more than reasonable particularly at current low interest and inflation rates. We are also reassured by the impact that enhanced scrutiny of management, boards, and accountants and recent aggressive prosecution of offenders is having on financial reporting. Whether moderating GDP growth leads to a recurrence of recession in the short term or not, there is little question in our minds that stocks will perform much better than bonds over the longer term. We are comforted enough by these factors to maintain current equity holdings in balanced accounts, confident in the longer-term prospects of the quality companies that we emphasize, while we await visible evidence of renewed economic momentum. – J.White