Why The Dow's Surge Was Hard To Divine
Market forecasters use all kinds of tricks to predict the stock market, from the length of women's skirts to whether the NFC or AFC wins the Super Bowl. But almost from the moment the market began its record-setting climb to Dow 10,000, in 1982, the experts failed to grasp what was happening. More often than not, some of Wall Street's best minds underestimated the swiftness and power of the bull market's run. Just ask Jeffrey Vinik, ex-manager of Fidelity Investments' Magellan Fund. He resigned in 1996, after he became convinced that the market would correct--and effectively kept Magellan on the sidelines as the bull kept charging.
How is it that on the road to Dow 10,000, so many were so wrong? Over the years, numerous seers, including prominent economists, market strategists, and, yes, journalists predicted just the opposite--that today's record valuations could not hold and a bear market or an outright crash would occur at any moment. Once in a while they were right: Elaine Garzarelli's famous prediction of the 1987 crash, for example. But more often, the seers didn't get the whole picture. And the reasons behind that myopia reveal much about what has driven the market's powerful surge, and what might push it up further--or sink it--in the future.
Predicting markets is certainly no easier than forecasting the economy or any other complex phenomenon. It may also be true, as Lehman Brothers Inc. market strategist Jeffrey Applegate notes, that "this market cycle isn't marked by any greater degree of stupidity than any prior cycle."
Still, traditional forecasting failed often over the past decade. And along with Wall's Street miscues, major business publications and other news media warned that the good times were about to end, largely echoing the views of pundits who, ultimately, were wrong. In recent years, The Economist, Fortune, Forbes, and Money all ran cover stories sounding the alarm.
RESILIENT ECONOMY. Most often, the pundits go wrong by extrapolating too much from the information they're using. BUSINESS WEEK did this famously in 1979 with a cover story that predicted "The Death of Equities." The thesis was valid: As long as inflation remained high, investors would avoid equities in favor of commodities and bonds. But those circumstances started to change in late 1982. And by May, 1983, BUSINESS WEEK's cover was proclaiming "The Rebirth of Equities" as the bull market was gathering steam.
Some of Wall Street's savviest veterans have also made mistakes. Merrill Lynch & Co.'s top strategist, Charles Clough, and Cantor Fitzgerald's Bill Meehan have been bearish on equities for more than two years. Noted technical analyst Robert Prechter was among the first to predict the 1987 crash, but in 1995, as the Dow neared 5000, he wrote that the Dow would dive below 500.
Even Wall Street's most respected strategist, Goldman, Sachs & Co.'s Abby Joseph Cohen, missed Dow 10,000. She earned her reputation by avoiding hyperbole--exuding a sensible bullishness and continually reassuring investors during setbacks that the long-run picture for equities remains strong.
Prudential Securities technical analyst Ralph Acampora has famously vacillated between bullish and bearish tacks, but with good results. Last August his indicators told him to turn bearish on the market, and he avoided its fall swoon, only to become bullish again in September.
One reason the path to Dow 10,000 has been littered with broken forecasts is that old models have proven unreliable. Stocks used to respond predictably to a well-defined set of variables, including inflation, interest rates, and growth of corporate profits. All of these remain important. But the powerful, increasingly technology-driven U.S. economy has had such a dramatic impact on both corporate profits and investor behavior around the globe that traditional guideposts have not applied. "People missed this bull run because they tended to rely on static economic models" developed decades ago, says Applegate.
One area that has stumped experts has been the economy's resilience. Last fall, when the meltdown in emerging markets spread and took down U.S. equities, analysts and business publications quickly concluded that, as Fortune put it, "The Crash of '98" had arrived: The bull would fade as the market revalued along traditional lines--which might take the Dow below 6000.
Edward E. Yardeni, Deutsche Bank's chief economist, also predicted a sharp sell-off before it happened last fall. He turned bullish again last October, but now he's bearish again, putting the Dow at around 7400 or lower by yearend because the Y2K problem will wreak havoc on earnings. Yardeni, in 1995, was among the first to predict Dow 10,000 in 2000. He says many misjudged the market because they underestimated the power of baby boomers pouring money into the market and overemphasized worries that strong growth would ignite inflation and boost interest rates. Instead, "we've had the best of both worlds," he says. PaineWebber Inc. strategist Edward Kerschner says people "haven't understood that the impact of low inflation on equities goes up geometrically when interest rates fall."
"AT ANY PRICE." Strategists have also underestimated investors' eagerness for high returns. The growth of mutual funds has led to trillions of dollars pouring into stocks. And fund managers, under constant pressure to outperform market indexes, are paying ever-higher prices for stocks. Two years ago, Fidelity Investments abandoned its practice of not buying companies it saw as overpriced. Instead, it has now decided to pay up for companies with strong, sustainable profit growth. Now other money managers "are looking at the best companies in any industry and are basically buying them at any price," says Edward Nicoski, market strategist at U.S. Bancorp Piper Jaffray.
Another sign of foolish excess? Sure, say the bears, noting that the market's rise has been driven by a relative handful of large-cap darlings, while lots of other stocks languish. Nicoski says the average stock has fallen 23% over the past 12 months. "The market is very vulnerable to a major shock," he says.
Cantor Fitzgerald's Meehan takes issue with the view that today's high stock prices are justified because the so-called New Economy has ushered in an era of higher productivity, low inflation, and full employment. "When there's a speculative bubble it's easy to think things will be different this time, and it's a new era," he says. Maybe so, but that's the kind of thinking that failed to predict Dow 10,000.