midyear investor's guide 2003

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    Can Stocks Defy Gravity?
    That's what Wall Street wants you to believe. Don't buy it. The best minds
    say the market will rise, but it won't soar.
    Monday, June 2, 2003
    By Shawn Tully

    The war is over, stocks are surging upward, and--admit it--you are starting
    to fantasize that it's 1999 again, and your 401(k) is going to fatten up
    with 10%-plus returns. You're thinking once more about retiring at 55 and
    maybe, just maybe, buying that cozy cottage on the lake. Heck, why not be
    optimistic? The experts are. According to the latest First Call survey,
    stock analysts are now predicting double-digit jumps in earnings this year
    and next, and projecting that the S&P 500 stock index will gain a
    holly-jolly 25% by the time Santa arrives in 2004. Of the 12 strategists who
    forecast the S&P, nine are raging bulls. Big companies, too, cheerfully
    predict that their pension funds will puff up with double-digit equity
    gains. If Goldman Sachs strategist Abby Joseph Cohen, blue-chip
    corporations, and the assorted Panglosses on CNBC's Squawk Box have faith
    that the stock market will soar again, why not you?

    Indeed, in the next few months these incurable optimists could be proven
    right. (Such enthusiasm has already lifted the S&P by 8% this year.) But
    most of us are interested in stocks for retirement, for college savings--in
    other words, for the long term. And in the long term the double-digit crowd
    is dead wrong. And wrong even if the war in Iraq is over, corporate
    credibility has returned (somewhat), and Big Mo is back.

    As we said, you won't find many Wall Street analysts and strategists telling
    you that. Despite the recent "global settlement," their specialty remains
    coming up with reasons for you to buy stock. The reasons can sound sensible
    on the surface, particularly if the result is what you want to hear. The
    bullish prediction going around today is that low interest rates combined
    with a growing, if not booming, economy will mean years of 10% or more
    returns on stock market investment. We're here to tell you that the numbers
    don't add up.

    For the real story, we turned to some top quantitative scholars. This cabal
    of quants follows the market's most fundamental math, and it's telling them
    that investors should downsize their expectations. Yes, some individual
    stocks will return 10% or better. And yes, even we at Fortune think we can
    identify a few of the winners--as you'll see in the stories throughout this
    special issue. But the best the market as a whole can pull off is 6% to 8%
    annual returns. For those who've grown accustomed to watching their pension
    funds shrink quarter after quarter, that's good news. But it's not
    jump-for-joy news. In other words, the market is likely to rise at the pace
    of a pack-a-day couch potato, not a sleek sprinter.

    Of the cautious scholars we turned to, one of the best is Cliff Asness, a
    burly, bearded University of Chicago Ph.D. who writes influential studies in
    academic journals while running the $5 billion hedge fund AQR Capital
    Management. By shorting absurdly priced tech stocks, and focusing on cheap,
    out-of-vogue value plays, Asness has defied the downturn, posting big,
    bull-market-sized returns since 2000. Asness believes it's time for what
    novelist John O'Hara called "sermons and soda water." "The market's math is
    irrefutable," he frets. "But as we see every day, it is ignorable."

    Asness is not the only scholar urging caution. He's joined by such
    heavyweights as Kenneth French of Dartmouth, who wrote some of the most
    important stock market studies of the past two decades with Eugene Fama of
    the University of Chicago. Also in this pack is Jeremy Siegel of Wharton,
    whose book, Stocks for the Long Run, helped mold academic thinking on how
    equities perform over long periods. They have all come to the same cautious
    predictions about the markets because a crucial number in investing--their
    Holy Grail--is pointing toward lower returns. That number is the "equity
    risk premium." Since the mid-1980s the risk premium has been one of the key
    concepts in academic work on the stock market. "It's the core number," says
    French. "If anything exercises a gravitational pull on stocks, it's the risk
    premium." (We'll show you how to calculate that crucial figure in a moment.)

    Wall Street doesn't say much about the risk premium, perhaps because it
    contradicts happy talk. While you may never have heard of it, the concept is
    familiar to the average investor: In short, it's the extra compensation
    investors demand for putting their money in stocks rather than ten-year
    government bonds, one of the safest investments. Or, if you're
    mathematically minded, think of it this way: The risk premium is the spread
    between what those bonds pay and what stocks are likely to pay (based on
    earnings growth and dividend yield) in the future.

    When the risk premium is wide, stocks are attractive and investors can
    expect fat returns. When it's low, the math decrees that future gains will
    be paltry. The risk premium has varied widely over time, usually acting as
    an excellent indicator for where stocks are heading. During the past 50
    years the risk premium has averaged 5%, for example. And over that time
    stocks have posted 10.5% average annual gains. In 1929, just before the
    Crash, the risk premium stood at zero. In 1972, it hovered at 3%, predicting
    the lackluster returns of the next decade.

    And where does it stand today? Right back at 3%. How do the quants arrive at
    this not-so-magic number? With Asness as a guide, let's walk there. He uses
    a formula that's well accepted in academic circles: The risk premium is the
    total projected return on the stock market--the S&P, say--minus the yield on
    bonds. To get the projected return, you take the dividend yield--the
    dividends S&P stocks pay out every year divided by the price of those
    shares--plus the projected capital gain. Today's dividend yield is around
    2%. (Asness raises it to 2.25% to credit part of the retained earnings spent
    on stock buybacks, which are just another form of dividends.) That's just
    half their historical average of 4.5%.

    Now let's go to capital gains, or improvement in share price. That equals
    the projected growth in earnings per share, as long as the price/earnings
    ratio stays constant. How fast can we expect earnings per share (EPS) to
    grow? Take a deep breath. Mining the best academic studies, Asness reckons
    that EPS has grown just 1.75% annually, adjusted for inflation, in the past
    50 years--more than one full point lower than the gross domestic product.
    (Earnings make up one part of GDP; other components include government
    spending and private investment.) So let's plug in 1.75% for earnings growth
    and hence capital gains.

    That means at today's prices you can expect to collect 2.25% a year in
    dividends and another 1.75% in capital gains--or 4%, before inflation. Add
    in an estimated 2% to 3% for inflation, and your total projected return is
    6% to 7%; let's take the midpoint of 6.5%. Now, to get the risk premium,
    subtract the ten-year Treasury bond yield of 3.5%. Presto! The risk premium
    is 3%.

    There's a purpose to this wonky exercise (and, trust us, it's not to give
    you a headache). What it tells you is that you can, over the next several
    years, expect to collect just 3% more on your stock portfolio than you could
    on government bonds. Asness and his brethren look at that figure and see two
    possible scenarios: The best case would be a slow but steady
    returns--perhaps by some 6% to 8% a year for the next decade. It could go as
    high as 8% if earnings rise more energetically than they have historically.
    The alternative is much less appealing: a sharp fall in the market followed
    by big percentage gains as investors pick up stocks cheaply. The reason the
    quants don't foresee huge gains from current levels is that, despite the
    drop in the markets, stocks are still expensive. What Wall Street doesn't
    tell investors is that in order to get 10% returns or better in the future,
    the folks in the market today will have to lose their shirts. Warns Asness,
    pouring the soda water: "Any big rallies from current levels must eventually
    be given back. They would take us back into bubble territory."

    It is possible to calculate a higher risk premium, and therefore higher
    projected stock returns. And no doubt optimistic Wall Streeters do. But to
    get to a higher number, you have to assume one or more of three things:
    either that interest rates will drop (making government bonds less
    attractive), or that P/E multiples will rise (as happened during the tech
    bubble), or that earnings are going to grow significantly faster than GDP in
    the long term. None of those scenarios is likely. Interest rates are at
    40-year lows. At 24, the P/E of the S&P 500 is already 71% higher than its
    historical average of 14 and would be hard-pressed to rise further. (Today's
    low earnings make P/Es look artificially high. By a more common measure
    based on the past year's corporate profits, the P/E would be 30; to get to
    24, we're using a method developed by Robert Shiller of Yale that averages
    earnings over the past ten years.)

    As for higher earnings, it's conceivable that a massive surge could push
    returns back over 10%. But once again, look at the math. To go from 6.5% to
    10%, earnings growth must rise from the historical average of 1.75% to
    5.25%. The profits of mature publicly traded companies historically have
    gone up only two-thirds as fast as GDP. So annual GDP would have to
    increase, on average, by well over 7%, something that has never happened for
    a sustained period in U.S. history. "Better-than-average earnings, if they
    happen, could get us to perhaps 8%," says Siegel. "But 10% assumes earnings
    growth that is just too big."

    There's another reason you aren't likely to see those 10.5% average gains,
    and it has everything to do with human behavior. Stock prices rose
    dramatically over the past half-century not because profits exploded (they
    didn't), but because the risk premium shrank. Asness, Siegel, and French
    surmise that it contracted because of the psychological shift that brought
    ordinary folks into the markets. Over the decades investors simply warmed up
    to stocks. A lot of things happened to make buying stocks safer, cheaper,
    and more customer-friendly. Mutual funds and index funds radically cut the
    costs of achieving a diversified portfolio. Capital gains taxes dropped. An
    enlightened monetary policy smoothed the bumps in the business cycle.

    In short, ordinary folks decided equities weren't so scary after all. They
    no longer needed that fat 5% spread over bonds. So companies got away with
    selling less of their equity, as it were, for the same investor buck. Or to
    put it another way, shareholders got a smaller slice of the company's
    earnings-and-dividend pie per invested dollar than they had years before.
    (It's like a cereal company giving you fewer corn flakes in the same-sized
    box!) As the risk premium fell during this era and people turned hot on
    stocks and cooler on bonds, P/E multiples jumped: Investors got roughly the
    same "E" for a much higher "P." (Risk premiums and earnings multiples always
    have an inverse relationship.)

    The biggest shift toward stocks happened between 1982 and 1999. In the
    recession of the early 1980s the risk premium stood as high as 10%, and the
    P/E as low as seven. Neon signs were blaring buy stocks! That high risk
    premium proved an excellent guide to returns to come. Even after the crash
    of 2000 and three straight years of stock declines, the shrinking risk
    premium drove P/Es from below ten to today's normalized figure of around 24.

    We probably won't see those trends repeated. The big behavioral change that
    drove the masses to the market--and drove P/E levels up--can't happen again.
    Extrapolating past returns from that behavior is Wall Street junk science.
    Without the juice of expanding P/Es, investors must console themselves with
    what's left, a combination of low dividend yields and modest earnings
    growth--that's our 6.5% a year.

    A 6.5% return on your large-cap index fund is not bad. You still have an
    edge over bonds. And new investors are beginning their long climb at a much
    more agreeable starting point than those who came into the market in the
    heady days of 2000, when the risk premium sank to zero. (Yes, this figure
    predicted the crash that followed.)

    For investors, the message is sobering but clear. If you have a very long
    horizon, stocks will provide a better return than bonds, but if you are
    planning to retire soon or need the money for your children's college next
    year, you don't have much of a cushion in the stock market. "With the
    narrower risk premium, you still win more than you lose in stocks, but the
    possible scenarios where you lose loom larger," says Asness. So your glass
    is half full. But this time, the bubbly drink is soda water, not champagne.

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