Get Used to It: The Wall Street Party Is Over

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    Article from the Washington Post

    Get Used to It: The Wall Street Party Is Over

    By Allan Sloan
    Tuesday, June 4, 2002;

    When the Dow Jones industrial average broke through the 10,000 mark in 1999, it was a very big deal. But when the Dow broke 10,000 last week, no one celebrated. That's because it broke the barrier in the wrong direction: down.

    It was the kind of week, all too typical of late, in which depressing news weighed heavily on the market. There was the revelation of yet another Securities and Exchange Commission investigation of a major corporation's accounting -- the corporation is Halliburton, and the probe could reach to Vice President Cheney, who was running the company at the time. There was the now-usual run of credit downgrades, profit shortfalls and weak-dollar alarms, plus genuinely scary things such as the prospect of nuclear war in Kashmir and more terrorist acts in the United States.

    It makes you nostalgic for those days of not so long ago when the market was a magic carpet ride of double-digit annual increases, creating enough wealth to let us all retire at 40 and solve societal ills (such as budget deficits, inadequate retirement savings and Social Security shortfalls) in the process. We're in a temporary lull, right? The Wall Street party will begin again soon, right?

    Wrong. Sorry to be a party pooper, but the bull market that defined a generation and linked Main Street and Wall Street more intimately than ever is over, and it won't be back for years and years -- maybe not in our lifetimes. We're still married to the market because we need each other, but we've lost that lovin' feeling. The days of a boring old Standard & Poor's 500 index fund doubling the value of your portfolio every 3 1/2 years are gone, gone, gone. The 30 percent S&P decline and the 70 percent Nasdaq decline from their peaks in March 2000 are a return to reality, not a passing hangover that will vanish tomorrow night when the party resumes.

    The long bull market threw almost everyone's sense of proportion out of whack. Anyone who's wondering why the market is so low may get really upset to hear this, but the market is still pretty high in the overall scheme of things. A key measure of stock valuations is the ratio of the S&P 500's price to the earnings of the companies that make up the index. Right now, the S&P is selling at 26 times its most recent year's earnings, almost double its historical average.

    That doesn't include the impact of the S&P's recent change in the definition of profit to include the cost of employee stock options, which will probably reduce earnings more than 10 percent this year. Not only are stock prices high by historical ratios, but corporate America is in disrepute, the economy is less than stellar, and more and more experts are calling our biggest wealth generator -- housing prices -- a bubble that's bound to burst.

    Despite all this, the Dow is hanging in there at around 10,000. And large parts of the market, such as smaller stocks and "value issues," which are cheap relative to asset values and earnings, have been doing reasonably well. These things were the wallflowers during the wild Internet-telecom-technology party in the late '90s, but they're the hot stars these days. Though not necessarily tomorrow.

    No one knows what stocks are going to do over the next decade or so. But I'll depart from my normal "Who knows?" posture and predict that returns won't come anywhere close to what people got used to during the late, lamented bull market. It's a can't-miss prediction, the only kind I like to make. The bull market, which I define as running from August 1982 through March 2000, produced an S&P return of a tad under 20 percent a year, according to Ibbotson Associates, a Chicago advisory firm. That's more than double the 8.9 percent average of the previous 56 years. Here's the math. At 20 percent a year, compounded, it takes 3.6 years for your portfolio to double. At 8.9 percent, it takes a bit more than eight years. A major, major change.

    Logic suggests that for the next decade or so, stock prices won't increase much faster than corporate earnings, which typically rise about 7 percent a year. Throw in an additional 1.5 percent or so for dividends, and you end up with a return -- dividends plus stock price increases -- in the high single digits. And getting that return depends on price-to-earnings multiples staying at their current high levels, which is no sure thing.

    "We are starting out at high valuations," said Ted Aronson of Aronson+Partners, a Philadelphia consulting firm. "During the bull market, price-earnings ratios tripled. They're not going to triple again." This isn't to say that stocks will never have a 20 percent year. It means they won't average 20 percent for years on end, as they did during the good old days.

    All sorts of high expectations are still embedded in the economy, and in many people's minds. Take the California state budget, which had done amazingly well in recent years because Californians paid staggering amounts of state tax after cashing in stock options and realizing capital gains. The state says it now has a $19 billion budget shortfall because those payments are far less than projected. There's the same problem with the federal budget. Capital gains tax receipts rose from $89 billion in 1998 to $126 billion in 2000 and probably fell well under $100 billion for last year.

    The idea of "reforming" Social Security by giving people individual stock market accounts -- another idea born of the bull market -- isn't looking too great either. Whatever your ideology, ask yourself this: How would you like to be cashing in your private Social Security account in this market, where you get pummeled by the combination of lower stock prices and lower interest rates on the annuity you buy with your account balance? Besides, if you look at the report issued by the president's Social Security commission, which consisted entirely of pro-privatization people, you see that creating private accounts would require megabillion-dollar subsidies from general tax revenues. That money isn't likely to be available, given President Bush's tax cuts, the less-than-robust economy, market-related tax shortfalls and increased defense spending.

    While people wait for "normalcy" -- which they define as rising stock prices -- to reappear, the 27-month bear market has wiped out many of the outsized gains investors racked up in the late '90s. The S&P has returned less than 1 percent a year for the past four years, according to Aronson+Partners. That's less than money-market funds. For the past two-, four-, five- and 10-year periods, the stodgy old Dow has outperformed the Nasdaq. And here's a stunner. Richard Bernstein, chief U.S. strategist for Merrill Lynch & Co., calculates that if you invested a dollar in the sexy Nasdaq composite when it started in 1971 and also invested a dollar in the yawn-inducing S&P Utilities Index, your utility investment would be worth more. The explanation? The utilities tortoise has beaten the Nasdaq hare because it has paid higher dividends. Over 30 years, dividends really make a difference.

    In a 20-percent-a-year world, dividends don't matter much. In a world of 6 or 8 or 10 percent, they matter a lot. Get used to it. Investors survived and prospered, gradually, for 56 years, averaging less than 9 percent a year. So can you. Put away the party hats and noisemakers. Welcome to reality.

    Benita Newton contributed to this column. Sloan is Newsweek's Wall Street editor. His e-mail address is [email protected].

    © 2002 The Washington Post Company
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