Investors Without a Compass

With stock-valuation models pointing in different directions, anxiety levels are rising

How bad will the stock market get? That's the $10.8 trillion question -- roughly the market value of Corporate America -- two weeks after the terrorists struck at the heart of Wall Street and American capitalism. In the first five days after trading resumed, the Dow Jones industrial average suffered its biggest weekly percentage decline since 1933, falling 14.3%, to 8236. Over that weekend, Wall Street investment strategists started talking up the bargains created by the torrent of selling. And by Sept. 26, the Dow had recouped to 8567.

So far so good -- but don't breathe too easily yet. Even if the worst of the sell-offs is past, the stock market is in for some wild times, with sudden swift movements and heightened day-to-day price volatility. The best guess is a Dow stuck in the 8000s for some time.

These next few weeks would have been a troublesome period even without the events of Sept. 11. Now, with America's frightening vulnerability to terrorism so blatantly exposed -- and recession far more likely -- investor confidence will be sorely tested. The uncertainty raised by the military, political, and diplomatic maneuvers can't be quantified into a stock-valuation model.

Several such models are signaling that stocks are significantly undervalued. The so-called "Fed" model, which relates earnings and interest rates, shows 13% undervaluation. Some dividend-discount models, which also incorporate earnings growth and risk, point to 15% undervaluation.


  But those models rely on forecasts in which investors have some confidence, and that is in short supply. Consumer confidence, while not the same as investor confidence, is a good proxy, since 84 million people own stock, directly or through mutual funds. On Sept. 25, the Conference Board reported that consumer confidence plummeted in August by the largest amount since the Persian Gulf War buildup in 1990. "I'm concerned investors will become more pessimistic than economic conditions justify," says Jeremy J. Siegel, author of Stocks for the Long Run and a finance professor at the University of Pennsylvania's Wharton School.

Of issues that can be weighed and measured, earnings are front and center. The first profit reports for the third quarter will come out in early October. Investor expectations are already low -- earnings on the S&P 500 companies are forecast to be down 28% from last year's third quarter. Still, the question is: Are the estimates low enough? Worse-than-expected news and, more important, what companies have to say about the coming quarters could also further hit stock prices.

The calendar raises the anxiety level, as well. October is associated with market crashes -- 1987 and 1929 are most notable, but the 1997 and 1989 sell-offs were nasty, too. Then there are bookkeeping issues. Mutual funds are required to make distributions by Dec. 31, and as a result, a lot of portfolio trading takes place in October. Any rallies that do get under way could run into selling from the fund managers eager to salvage what little profit they can. If fund investors start redeeming en masse -- and so far, they're not -- that will step up the selling even more. Individuals have until Dec. 31 to sell stocks in order to take losses on their 2001 tax returns.


  Still, there are countervailing forces. The Federal Reserve has been aggressively cutting short-term interest rates since January, and it takes about a year to start lifting the economy. The stock market typically anticipates the recovery three to six months ahead of time. So if the rate cuts work, stocks should start to show it soon.

There are other pluses, too. Energy prices, which rocketed earlier this year, are rapidly falling. Since Sept. 17, crude oil has plunged 22%. That will help battered profit margins and free up some cash for consumer spending.

Finally, the bear market -- the second-worst in 50 years -- could be viewed as positive. The 36.8% decline in the S&P 500 since its March, 2000, peak has wiped out lots of speculative excesses. Even before Sept. 11, margin debt had come down to early 1999 levels, and more debt has been extinguished since then.

What's more, as the quarter ended, the S&P 500 was headed toward its sixth double-digit third-quarter loss in the past 50 years. Each time before, says Arnold Kaufman, editor of Standard & Poor's Outlook, the market has rebounded an average of 10% in the following quarter.

That may not happen this time. After all, investors are facing a peril without precedent that will temper any rebound. What's shaping up is an angst-ridden market stuck in a trading range.

By Jeffrey M. Laderman, with David Henry, in New York