The Good News in All That Bad News
On July 15, Nan Hudes, a marketing director at a New York publishing company, made one of the toughest decisions of her life. At about 2:15 p.m., after watching the Dow Jones industrial average nosedive by more than 400 points, she sold all of her stocks except those in one small 401(k) account. "I just couldn't take it anymore. I kept putting money in, and it kept going down," says Hudes, a grandmother in her 60s. Her net loss: about $260,000 from the peak--money she was going to use to retire in three years. She immediately put her remaining $150,000 into bond funds and cash. "I'd be much less upset if I was 40 and had time to make that money back. But at this age, forget it. It's gone."
As investors become more and more disenchanted with equities, the market continues to suffer one of the most vicious sell-offs in memory. The Nasdaq and Standard & Poor's 500-stock index are back to 1997 levels, wiping out $7 trillion in value from the market's peak. And the Dow has dropped to its lows of late last September. It's the Dow, in particular, that has investors worried. The index, which consists mainly of Old Economy, more stable companies, had held up better than the rest over the past nine months. But through July 16, it fell seven days in a row, losing almost 10% of its value.
Millions of investors are reeling from their losses. In a July 9 survey by the American Assn. of Individual Investors, 42% of respondents said they're bearish and 35% bullish. That's an about-face from January, 2000--just two months before the Nasdaq crash--when only 13% were bearish and bulls hit an all-time high of 75%. And a recent Gallup poll found that people's trust in corporations has fallen to a new low. "We've gone from the democratization of equities to the demonization of equities," says Tobias M. Levkovich, institutional equity strategist at Salomon Smith Barney.
Foreign investors, who had about $1.7 trillion invested in U.S. stocks at the end of the first quarter, are also much less enthusiastic, dramatically cutting their investment here. That's partly due to the weak dollar: As foreigners see shrinking returns on dollar-denominated assets, they put less money in U.S. stocks and take more home, worsening the market's decline. European insurers and pension funds, in particular, are under pressure to dump U.S. equities.
The stock market rout could begin to take a toll on the economy. Although it has remained amazingly resilient, Federal Reserve Chairman Alan Greenspan said on July 16 that the economy may not recover as fast as expected because of wounds from corporate scandals coupled with the severe drop in stocks. Also, while consumer spending has held up so far, it could start to slow because of stock market losses. Investors such as Hudes, whose net worth has more than halved, are simply spending less. "When I had all that money, I was more than happy to spend it. Let's just say Saks Fifth Avenue got a lot of it, but not now," she says.
If consumer spending slows, that could hit companies' bottom lines and, in turn, drag down their spending. Corporate profits are also under pressure from factors such as pension funds, which are becoming radically underfunded because of the bear market. For instance, General Motors Corp. (GM ), which lost 3% on its pension investments this year, will have to plow $9 billion into its fund over the next five years to comply with accounting standards. Says GM Vice-Chairman and CFO John M. Devine: "We aren't looking for the market to bail us out." Then there are stock options. If companies follow Warren E. Buffett's advice and start expensing them, their bottom lines will suffer another blow.
Yet the gloom is so widespread that many investment strategists are taking heart. For starters, it means the Federal Reserve is unlikely to raise interest rates for six months or more. Even better, they say, investors are so discouraged that they're sending a strong contrarian signal that the market may turn up soon. "Assuming the earnings rebound in the third quarter, as we expect, this could mark the beginning of the bottoming for stock prices," says Edward M. Kerschner, chief global strategist at UBS PaineWebber Inc.
But for now, people are cashing in equities like crazy. Investors started bailing out of stock mutual funds in June. With the exodus accelerating in early July, funds are now facing a crunch: Redemptions mean that managers don't have enough cash to buy stocks even if they want to. "The outflows could put a damper on the market for some time to come," warns Thomas McManus, chief investment strategist at Banc of America Securities. According to Trim Tabs, which researches money flows, there could be $59 billion in outflows in July--far more than was pulled out after September 11.
Some of the biggest mutual funds are caught in the squeeze. Janus Fund had $25.6 billion in assets, including $300 million in cash, at the start of the year. But investors pulled out $1.6 billion through May 31, according to Financial Research Corp. What's more, "there's a concern that equity flows might not turn back as fast as they have in the past with a market rebound," says analyst Robert Lee of broker Keefe, Bruyette & Woods. The reason: Most of those cashing out are investors nearing retirement--who control the largest amount of assets.
Large mutual-fund redemptions aren't the only force driving the market south. Institutional traders, especially hedge funds, are playing havoc with already troubled stocks. "Hedge funds are very active, very aggressive in this market," says Laszlo Birinyi of Birinyi Associates Inc. Birinyi, who studies money flows, thinks hedge funds could account for as many as one out of four trades. "This is the crowd that has to figure out ways to make money in any market environment because investors demand it," says Bernard Schaeffer, president of Schaeffer's Investment Research Inc. in Cincinnati. And because hedge funds tend to short stocks and play big in options, they exert intense downward pressure on the market.
Some market players think hedge funds are adding to sky-high volatility and creating some of the wild price swings by spreading negative rumors after they've shorted a stock. Short-sellers have always endured this tarnished reputation. But in this market, the claim may hold more weight. Investors who are already skittish after tales of corporate malfeasance and market declines are dumping shares at the first whiff of trouble, real or imagined. "The portfolio manager who has just gotten his head handed to him on Enron and Tyco (TYC ) is just saying, `Get me out. I don't care if it's true,"' says Scott Hill, a Sanford C. Bernstein & Co. auto analyst. In fact, trading in General Motors stock was halted on June 26 after a succession of rumors, which were later proved untrue, tanked the stock.
Investors have undergone a profound psychological shift. Banc of America's McManus says the "buy on the dips" strategy so popular in the '90s has given way to new mantras: "Prepare for stocks to go lower," and "even after stocks hit bottom, returns are likely to remain sub-par for many years." During the '90s market bubble, it seemed stocks only went up. Now, the opposite is true. "The market is feeding on itself on the downside just as it fed on itself on the upside for seven years," says Barry Hyman, chief investment strategist at Ehrenkrantz King Nussbaum. Indeed, "suckers' rallies"--when stocks soar for a day, then dramatically drop--are depressingly frequent now. "You get these upward trends, but they never hold. People are so shaken by these company scandals. We need some certainty--some good earnings numbers," says Robin Dayne, a trading coach in Las Vegas.
Actually, profits have already started to turn up. According to Thomson Financial/First Call, S&P 500 earnings are expected to rise 3% this quarter from a year ago. And because year-over-year comparisons will be based on last fall's depressed profits, third- and fourth-quarter earnings should start looking much better--up 16% and 28% respectively.
But investors are still leery of the numbers--with good reason: If all S&P 500 companies expensed stock options, earnings would have been 24% lower in 2001 and will be an estimated 17% less this year. "Worries about the validity of earnings have added to highly charged emotion and despair," says Subodh Kumar, chief investment strategist at CIBC World Markets.
Could things get worse? Yes. President George W. Bush's demand that CEOs and CFOs vouch for annual financial reports starting on Aug. 14 could roil markets even more. That could bring still-rich valuations down. The S&P is trading at about 21 times projected earnings, compared with an historic average of 15.
Many Wall Street strategists say all the bad news is actually good for the market. Even erstwhile bears are leaning more toward equities. "My feeling at the beginning of the year was bearish toward stocks and bullish toward bonds. But with the stock market coming down, we've shifted," says Byron Wien, U.S. investment strategist at Morgan Stanley. He expects the S&P to end the year down by single digits--not bad, considering it's currently down 21%. He and others think the market is undervalued despite the seemingly high price-earnings ratios. Why? Even if p-e's rise somewhat as cleaner accounting puts a damper on earnings, they'll still be reasonable because the underlying profits trend is up, and interest rates are at 40-year lows.
The massive fund redemptions look good to some. "The sentiment tells you stockholding is becoming vilified by a whole class of investors. By definition, the bottom is when there's no one left to sell. At the top, there's no one left to buy," says McManus. So we could be in the midst of a buying opportunity. Thomas Galvin, chief investment officer at Credit Suisse First Boston, notes that 88% of New York Stock Exchange stocks are trading below their 10-week moving average--indicating that they are aggressively oversold. Historically, the best recent times to buy--September, 2001; August, 1998; August, 1990; and October, 1987--were when 80% or more of stocks traded below this mark.
Still, it could be months--even a year or two--before the market stages a sustainable recovery. Once it does, there will be loads of cash waiting to drive it onward and upward. According to the Investment Company Institute, investors held more than $2 trillion in money market accounts in the week ended July 10, vs. $1.4 trillion at the peak of the bull market in 2000.
When the market finally does recover, investors can't expect anywhere near the gains realized in the late 1990s. UBS PaineWebber's Kerschner is calling for a "return to normalcy," in which annual gains of 7% or 8% will be more usual. And that will be just fine, thank you.
By Marcia Vickers, with Heather Timmons and Robert J. Rosenberg, in New York, and with Geoffrey Smith in Boston and David Welch in Detroit