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The Stock Market September 24, 2009, 5:00PM EST

Searching for True North

Investing gauges are broken, market signals are mixed, and money managers don't know where to turn. What exactly is the "new normal"?

By Roben Farzad

Well-intentioned people can disagree over the Great Recession's place in history. In one important sense, though, the chaos of the past 18 months has been unprecedented. It has shattered deeply held beliefs about the basic functioning of the stock and bond markets and left the best minds in finance—to say nothing of ordinary people—grasping for explanations.

The sacred texts of investing need to be rewritten. It turns out that the so-called equity risk premium, the once-sacrosanct belief that stocks perform better than bonds over time, has been vastly overrated. Earlier this year, according to the Leuthold Group, a Minneapolis research firm, U.S. Treasury bonds had outperformed U.S. stocks over the preceding 10- and 20-year periods. And that was only the beginning. Bonds also beat stocks over the past 30 years. Even the 40-year returns were basically equal, a feat never before witnessed in the U.S. markets. Over other periods, of course, stocks performed far better. But for four decades they were a sucker's bet.

If the bedrock principle of investing—that shareholders are compensated over the long term for the risk of buying equities—is a fallacy, then what, if anything, can investors believe in? Which assumptions can be trusted? What is "normal"? During the panic the markets were "way out of whack," says John H. Cochrane, a finance professor at the University of Chicago's Booth School of Business and vice-president of the American Finance Assn. "I don't know what's going to happen to the stock market next. And I have a highly educated view that no one today really knows."

Amid this cosmic confusion, two opposing theories are emerging. One group of prognosticators claims the markets are in the throes of a "new normal," a long period of slow growth during which old investing rules will give way to new ones. The other group says the epic abnormality of the past few years will soon be swept away by a massive reversion to historical patterns. Depending on whom you believe, today's stock market is either a trap door or a coiled spring.

Caught in the middle are thousands of professional investors searching for the market's true north. They don't have much time to fumble around: Their livelihoods depend on people believing that they know what they're doing. Managers of mutual and hedge funds are struggling to figure out not only how to make their customers money but also how to justify their fees. Financial advisers are rethinking outdated formulas of "asset allocation" as clients demand more safety. Pension fund managers face the politically dicey task of rebuilding their portfolios without taking on excessive risk or demanding bigger contributions. All are yearning for signals of how the future will play out.

STARVED FOR CAPITAL

The executives at Pacific Investment Management, or PIMCO, say they have the answer. The bond fund giant has adopted the phrase "new normal" to describe the changes taking place. "If you are a child of the bull market, it's time to grow up and become a chastened adult," writes William H. Gross, manager of PIMCO Total Return (PTTRX), the world's largest bond fund, in his September dispatch to investors. "It's time to recognize that things have changed and that they will continue to change for the next—yes, the next 10 years and maybe even the next 20."

PIMCO cautions stock investors to accept lower returns long into the future. In the new normal, says PIMCO, economic growth will continue to be slow and unemployment high as the U.S. loses clout to China and the rest of the emerging economies.

PIMCO CEO Mohamed A. El-Erian, a 15-year veteran of the International Monetary Fund who later managed Harvard University's endowment, contends that the economic crisis will run so deep that it will vanquish all assumptions about stock market valuations. As the economy's growth rate resets lower, he says, a broad swath of companies will find themselves starved for capital. The easiest, and increasingly only, way for them to recapitalize will be to issue more equity, "diluting" or even wiping out shareholders' assets. "That reality," El-Erian says, "is not captured in the equity risk premium model and what people assumed was normal. Stock prices will come to reflect this threat permanently."

PIMCO is in the belly of the recession beast. Its Newport Beach (Calif.) headquarters are in Orange County, aka Subprime U.S.A., home to cookie-cutter subdivisions populated and then vacated during the real estate boom and bust. The county famously went bankrupt in 1994 but collected itself enough to chase ruin anew a decade later. An eerie quiet pervades the place. Along the freeway, defunct mortgage startups have shrouded or dismantled their billboards.

Whatever just happened in the markets has been unmistakably good for PIMCO. The firm has taken in $120 billion of fresh assets since the start of 2008. Since its 1971 founding, PIMCO has increased its assets from $12 million to $842 billion, $180 billion of which is concentrated in PIMCO Total Return. That portfolio has returned an average of 6.34% over the past five years, well north of its 5.14% benchmark and the 2.25% loss posted by the Standard & Poor's 500-stock index.

El-Erian, who is also PIMCO's co-chief investment officer, is highly skeptical of the stock market's recent rally. "Interest rates are at zero, there's $2 trillion plus on the Federal Reserve's balance sheet, and yet the economy is still losing jobs," he says. "What exactly is the stock market romancing?" According to PIMCO's new normal, equities should make up just 30% to 54% of a portfolio, with no more than half in the U.S.—much less than the traditional 60% commitment to stocks and 40% to bonds.

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