Long-term faith in stocks wavers

Wall Street pretty much agrees that a successful invasion of Iraq by the United States and whatever allies it can round up would be good for the stock market.

Share prices will be "substantially higher by year end," says David Malpass, chief economist of Bear, Stearns & Co., a major investment firm based in New York.

Beyond such a rally, though, the financial community is divided and undecided on the course of stock prices. Perhaps the most significant question for investors, especially baby boomers facing retirement, is this: Will stock prices return soon to their historic growth pattern?

Since 1926, stocks (free of taxes, dividends reinvested) have provided an average annual return in nominal dollars of 10.7 percent. That's a sizable premium over the 5 percent return on bonds.

Three years ago today, the Nasdaq Composite Index bubble began to burst. It closed that March 10 at 5048. Last week the index was running around 1300. The index, with its heavy load of high-tech companies, has declined 30 percent in the past 12 months alone.

The Standard & Poor's 500 index hasn't been hit quite so hard. Still, it is down about 28 percent in the past 12 months.

"People have postponed their retirement because of what has happened to stocks," notes Mark Wohar, an economist at the University of Nebraska, Omaha.

Professor Wohar's hope is that the "New Economy" is real and sustainable, that computers and other innovations will boost productivity sufficiently that corporate earnings and the economy will flourish, and thus stock prices will thrive nicely in the future.

But he and others aren't so sure of that outlook.

Several major companies have been modestly lowering the expected return on their pension investments - for example, IBM from 10 percent to 9.5 percent, Fidelity Investments from 7.75 to 7, Citigroup from 9.5 to 8.

Economists at Goldman, Sachs & Co., an investment-banking firm in New York, predict the long-term return on equities will be about 6 to 6.5 percent a year. That implies corporations will have to trim their projected pension returns further.

One reason, explains chief economist Bill Dudley, is lower inflation. Over 40 years, the average inflation rate has been about 4 percent a year. It is now running between 1.5 and 2 percent.

To Mr. Dudley, the market debacle of the past three years has taught investors that stocks are riskier than bonds and some other investments. The "love affair" with equities has decidedly cooled.

"But people are not yet realistic," he says. "They are not saving enough from their income to have a good retirement."

Three years ago, Yale economist Robert Shiller's book, "Irrational Exuberance," was published. In it, he argued that stock prices in the 1990s displayed the usual features of a speculative bubble - "wishful thinking on the part of investors that blinds us to the truth of our situation."

One "truth" was that the ratio of stock price to earnings would return to its historic average of 15 or 16. The P/E ratio for the S&P 500 is now about 29, same as it was three years ago, because corporate earnings took a tumble since then.

If Mr. Shiller is right, prices still have a long way to tumble, warns Wohar. Those investors who hold on to their stock portfolios, counting on a rebound, could see their retirement funds dwindle further.

Much depends on the economy. If it picks up steam, earnings should follow. The P/E ratio could gradually improve. But Edward Yardeni, chief economist of Prudential Securities Inc., suggests that "deflationary pressures and rising pension costs" could trim expectations for long-term earnings.

During the stock-market boom, some bullish analysts maintained that stocks were no longer so risky. Therefore, the premium return that stocks command over bonds would shrink or even disappear. That shift would justify a higher P/E ratio than 15 or 16.

"What is kind of amazing with the United States market is that historically, its returns have been pretty robust," notes William Goetzmann, an economist at the Yale School of Management in New Haven, Conn. "The 20th century was the American century in many ways. But we don't know what the 21st century will be."

Maybe, investors need to reduce expectations for the market "a little bit," he speculated.

Facing many uncertainties at the moment, investors aren't demonstrating great confidence.

Stock prices are going up and down like a yo-yo. Last year, the S&P 500 index changed 2 percent or more in a day on 52 days. That's the most volatility since 1938. The index traded all of 1995 without such a change in one day.

Analysts suspect that millions of individual investors who normally just buy and hold stocks are bailing out, at least partly. Households were net sellers of $466 million of US equity funds in January after withdrawing $8.3 billion in December. Merrill Lynch analysts calculate that investors took another $9 billion out in February.

Some were fleeing into bond funds, which many consider safer, despite the risk that higher interest rates would depress their price. Fixed-income investments took in some $12.7 billion in January.

"Bottom line," note the Merrill Lynch analysts, "individual investors can be expected to (1) sell into rallies; (2) not buy into the 'dips' and (3) ignore the pundits, who on average are telling investors to have close to 70 percent of their financial assets in stock."

Such a gloomy view would have been unusual in a brokerage house a few years ago. Most firms prized positive views by their researchers. Analysts may be freer to present their honest opinions today.

"Nobody can predict when the market is going to turn around," says Goetzmann.

Stock-market forecasts are notoriously inaccurate.

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