Markets & Finance

Equities: Dead, or Just Resting?


The meltdown has left many wondering about stocks. BW Contributing Editor Chris Farrell thinks reports of their demise are exaggerated

These are truly scary times. The stock market has lost some $11 trillion in value since its October 2007 peak. Blue-chip companies like AIG (AIG) and Citigroup (C) are now penny stocks, while General Motors (GM) and Las Vegas Sands (LVS) trade at less than 2 a share.

It seems that everybody is scouring through the numbers, trying to figure out how far down is down—and how long this bear market will last.

And if the stock market train wreck isn't enough, investing icon Warren Buffett has come along with a new warning. "A few years ago, it would have seemed unthinkable that yields like today's could have been obtained on good-grade municipal or corporate bonds even while risk-free governments offered near-zero returns on short-term bonds and no better than a pittance on long-terms," he writes in his latest annual letter to Berkshire Hathaway (BRKA) shareholders. "When the financial history of this decade is written, it will surely speak of the Internet bubble of the late 1990s and the housing bubble of the early 2000s. But the U.S. Treasury bond bubble of late 2008 may be regarded as almost equally extraordinary." Great.

No Longer a Cornerstone

What is the average saver in a 401(k)-type plan supposed to do? Abandon equities? Flee bonds? (Sales of home safes are up, but that's not recommended.) Two simple market stories reinforce a time-honored lesson for all investing seasons. You don't have a clue what investment will do well going forward, and neither do the experts.

The first story: The old attitude of buying solid stocks as a cornerstone for one's life savings and retirement has simply disappeared. Younger investors, in particular, are avoiding stocks. In fact, the only reason the mutual fund industry has been able to survive the death of equities is the dramatic success of such funds which invest in T-bills, bank CDs, and other short-term paper. Says Alan B. Coleman, dean of Southern Methodist University's business school: "We have entered a new financial era. The old rules no longer apply."

Those thoroughly modern-sounding lines were plucked from one of the most famous cover stories in business journalism, BusinessWeek's August 1979 piece "The Death of Equities." Needless to say, BW's bold pronouncement became the favorite example of contrarians. (Type "The Death of Equities" into your search engine and you'll see what I mean.) Case in point: "By the end of the 1970s, things were so bleak on Wall Street that a pessimistic BusinessWeek cover proclaimed "The Death of Equities," Money magazine wrote last year. "That, of course, turned out to be one of the great buy signals of all time."

Really? The contrarian story doesn't stand scrutiny. Rereading it today, it's a well-reported, well-written article that thoughtfully looked at why individual investors were abandoning stocks nearly seven years after the Dow's peak and suffering through years of raging inflation. Here's the rub: The stock market didn't bottom out until August 1982—three years later. That's one long lasting contrarian indicator. Hopefully anyone who invested on the theory that magazine covers are useful contrarian indicators had very deep pockets and a long time horizon.

Vroom

The real lesson is that despite the gloom, the U.S. economy eventually recovered, inflation rates trended lower, businesses became more competitive, and innovation flourished, setting the stage for the bull markets of the '80s and '90s.

A second story: Remember Dow 36,000, the book co-authored by James K. Glassman and Kevin A. Hassert? It was published in 1999. "The Dow Jones industrial average was at 9000 when we began writing this book," the authors write in their introduction. By their calculations "in order for stocks to be correctly priced, the Dow should rise by a factor of four—to 36,000… The Dow should rise to 36,000 immediately, but to be realistic, we believe the rise will take some time, perhaps three to five years."

Oops. The Dow Jones industrial average peaked at over 14,000 in October 2007, and it's down by more than 50% since then. Worse yet for Messrs. Glassman and Hassert, from 1999 to 2009 the S&P 500 is down 50% adjusted for inflation, calculates Michael Mandel, BusinessWeek's chief economist. Their notion that stocks were almost a riskless security over the long haul was nonsense. Stocks are riskier than bonds since equities represent the uncertain rewards for entrepreneurship, while bonds are long-term contracts that spell out when borrowers must make principal and interest payments.

"There is no predestined rate of return, only an expected one that may not be realized," says Laurence Siegal, director investment policy research at the Ford Foundation. "The risk of holding stocks, then, is the possibility that in the long run, returns will be terrible."

Higher Return on Bonds

A close look at market history also shows that stocks did not always do better than bonds even with a 30-year time horizon before 1871, and after that bonds often outperformed stocks for 10-year periods. You don't even have to reach into the history books, either. From 1983 to 2008, the annual total return on stocks was 9.8% a year vs. an 11% average annual return on Treasury bonds. That should put to rest the "stocks for the long haul" dogma.

What is the individual investor trying to save for retirement to make of all this? The patterns of market history are such that stocks are sometimes seen as diamonds and bonds as zircon, and vice versa. Benjamin Graham, the investing legend, wrote in his 1949 masterpiece, The Intelligent Investor: "In the old legend the wise men finally boiled down the history of mortal affairs into the single phrase, 'This too will pass.' Confronted with a like challenge to distill the secret of sound investment into three words, we venture the following motto, MARGIN OF SAFETY."

Diversification is one way to build a margin of safety. It's a hoary lesson oft forgot. The Talmud recommends it: "A man should always keep his wealth in three forms; one third in real estate, another in merchandise, and the rest in liquid assets." Shakespeare in The Merchant of Venice has Antonio explain to his friends why he wasn't spending sleepless nights worrying over his investments.

"Believe me, no. I thank my fortune for it,

My ventures are not in one bottom trusted,

Nor to one place; nor is my whole estate

Upon the fortune of this present year.

Therefore my merchandise makes me not sad."

Don't Hark Back to the Depression

The other way to build a margin of safety is to hedge, or employ strategies to mitigate risk. For instance, Professor Zvi Bodie of Boston University is a leading proponent of hedging with retirement savings. He argues that the basic money question for the future retirees of America is not "How much money will I make on my investments?" but "How much can I afford to lose?" Take the amount you can't afford to lose and eliminate the risk with default-free, inflation-and-deflation proof Treasury Inflation Protected Securities (TIPS).

So, should we send flowers for the equity market and comfort its bereaved survivors? Don't back up the hearse just yet. My own sense is that there is wonderful value in the stock market. When was the last time you heard a professional money manager go on television and say, don't buy my fund? That's what Steve Leuthold, the market historian, long-time money manager, and head of Leuthold Group did on Bloomberg TV late last week. His Grizzly Short Fund—a mutual fund that typically sells stocks short—sports a one- year return of 84% and a year-to-date return of 29%.

So why is Leuthold recommending not to follow the hot fund? "These comparisons with the Great Depression are totally out of touch with reality, and pretty stupid," he says.

I think he's right. But I'm well-diversified just in case.


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