Commentary: How Long Can Investors Keep the Faith?

By Michael J. Mandel

Despite the 27% fall in Standard & Poor's 500-stock index since the end of last summer--and the 16% slide since the beginning of the year--there is little doubt that the U.S. economy and financial markets remain the strongest in the world. So far, the willingness of many investors to stay in stocks seems to reflect this confidence. Outflows from equity mutual funds in February, according to the latest figures from the Investment Company Institute, totaled only $3 billion, hardly touching the almost $300 billion poured into those funds over the previous year.

But such faith in the future can last only so long, given the torrent of negative announcements coming almost daily from companies as diverse as American Express Co. (AXP ) and Ariba Inc. (ARBA ) The history of previous booms, such as the U.S. in the 1920s and Japan in the late 1980s, suggests that investors maintain their faith in an eventual market rebound for about a year after stock prices and the economy start to slide.

If prosperity returns quickly, as it did after the 1987 crash, this confidence is justified. But when the economy keeps delivering news of falling profits and revenues, investors get worn down. They become much more willing to forsake equities in favor of safer investments--and that's when the biggest economic and financial damage occurs.

If this pattern holds, U.S. markets may be entering a critical period. Tech investors, already pummeled by falling prices since March, 2000, may make an even more profound retreat if they fail to see signs of a recovery--or at least a stabilization--in tech profits and revenues by late spring.

Faith in Old Economy stocks may last longer, since the broader S&P did not start its slide until late summer of 2000. But if the economy and corporate profits remain weak into the second half of 2001, the market could take another precipitous dive.

Why should it take a year for investors to readjust their expectations? A long economic and market boom trains them to buy on the dip. That means investors are conditioned to adopt a strategy of disregarding negative news, or even treat it as a buying opportunity. Thus, steep market declines--like the ones in 1987, 1990, and 1998--merely offered evidence that big moves downward are always followed by bigger moves upward. Indeed, the more dips there are, the more effective the conditioning.

Once investors have gotten used to this pattern, it takes a steady and sustained flow of negative announcements to convince them that bad news is here to stay. Witness the stock market crash of October, 1929, for example. Although in retrospect this event marks the beginning of the Great Depression, it was not so obvious at the time. Investors had become used to market and economic volatility. They had seen four recessions over the previous decade, each followed by strong economic and financial recovery.

A BIGGER SWOON. There was no reason, then, to panic after the October crash. The stock market was fairly stable for almost a year following the initial plummet. It was not until September, 1930, after a year of bad economic news had eroded investor confidence, that the market headed into another swoon.

It took somewhat longer to undermine investor confidence in Japanese markets in the early 1990s, after the long boom there. The Nikkei stock average peaked at the end of 1989 and fell nearly 30% in the first three months of 1990. But then stock prices bounced back, as politicians, economists, and business leaders issued a river of positive pronouncements about Japan's future. It was not until March, 1991, that investors finally understood that economic recovery was not around the corner. That's when the Nikkei started on its next sustained slide. It now trades off 66% from its late '89 high.

Perhaps today's U.S. investors will prove a hardier breed, more able to weather disappointment and concentrate on the long run. But while the economy may have changed, human psychology probably has not. Unless investors get some good news from the real economy, their commitment to the market may soon dry up.

Mandel covers the ups and downs of the New Economy.

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