Wall Street Risks

Goodbye, irrational exuberance. The market's next few years will be less spectacular, but much steadier--except for tech stocks

By David Henry. With Mara Der Hovanesian in New York.
Business Week

August 27, 2001

The stock market became a very risky place the past 18 months as the dream of riches from the New Economy faded into a nightmare. If you embraced the glorious vision of technology and bought into the Nasdaq in March, 2000, nearly 60% of that money is gone. Twenty percent is gone if you were more cautious and bought into Standard & Poor's 500 stocks. So severe is the reversal that if you had invested in the S&P 500 back in mid-1998 and held on for three years, your annual total return would have been a paltry 3.92%. Cash would have been a better investment. You would have earned an annualized 5.41% storing your dollars in safe three-month U.S. Treasury bills.

Now, in the aftermath of boom and bust, the next three years will likely be much steadier. Stock valuations are more reasonable now and are unlikely to swing out of hand, while investors are largely chastened by the forays in speculation.

But there's one glaring exception: tech stocks. Yes, they are down a lot. But their earnings are down even more, and their price-earnings ratios are still nearly twice as high as the rest of the market's--about 35 vs. 20, using analysts' earnings estimates for the next 12 months. Between the high prices and the time it will take for tech earnings to recover fully, the stocks probably won't begin to deliver decent returns for three years, if then. The fundamental problem is that these stocks continue to attract investors' capital out of proportion to the companies' profitability. Until more investors give up on the sector, the industry will put off consolidation and its profits will suffer.

For the market overall, the upshot is that you can look for annualized returns of about 7% over the next three years, in line with the long-term growth of earnings per share. That would be below the long-term historical trend of 11% returns and, for many people, disappointingly weak. But it would be an improvement over what we've got now, as well as a more accurate barometer of the actual benefits of a New Economy.

The basic reason to expect improving, but still below-trend returns, is that the market is still adjusting for the bubble in stock prices in the second half of the 1990s. Stocks produced gravity defying annual returns of 27.7% for the three years up to mid-1998, as measured on the S&P 500, says James A. Bianco of Bianco Research. Amazingly, stocks went even higher, gaining 34% by the March, 2000, peak. Before the boom was over, stocks had racked up five consecutive calendar years of 20%-plus returns, three years more than ever before. By then, stocks were so high that it was nearly impossible for the gains to continue to compound.

$1 Trillion Fantasy. Then came the bust. Given the spectacular losses in big tech stocks and that the S&P has been down nearly 30%, says Bianco, "the risks are a lot less." To see how much folly and risk has been cleaned from the market, consider Cisco Systems Inc. (CSCO ) The stock climbed in the boom to a market capitalization of $550 billion, the greatest in the market, and fed speculation that Cisco would be the first trillion-dollar company. Instead, Cisco collapsed, wiping out $400 billion in shareholder wealth in 12 months. Now the stock is worth just $145 billion, trading at 55 times earnings expected in 2002, and may still be too expensive, but at least the $1 trillion fantasy is gone.

Valuations in general have become safer, too, though they're still not compellingly cheap. With the S&P at a recent 1200, the price-earnings ratio for the market is 21.6, based on analysts' earnings estimates for the next four quarters of $55.62, according to Thomson Financial/First Call. That's down from a p-e of 25.4 in March, 2000.

The lower p-e means less risk for investors, but it has not fallen far enough to promise a charging bull of a market. "We've never started a bull market at these valuations before," says Brian E. Dombkowski, who oversees $3.5 billion in stock investments for Dresdner RCM Global Investors. Before a bull market begins even a trot, the market may have to mark time in a trading range to allow earnings to recover and bring p-e ratios down more. Today's low interest rates would make the market cheap at its average historical p-e of 14.

Investors might have to get more pessimistic, too, before the market can turn up. Right now, sentiment among Wall Street strategists is more bullish than anytime in the last 16 years, according to Richard Bernstein, chief quantitative strategist at Merrill Lynch & Co. He has found his peers as a group are wrong most of the time and are a contrary indicator of where the market is going over the next 9 to 12 months.

Still, even if there is an outright recession, the risks of a big drop in the market are lower than they were. Economist Steven Wieting of Salomon Smith Barney estimates that in a recession, the S&P 500 would have to fall by only 8%, to around 1100, to reach a p-e comparable to its level in the 1991 recession. Back then, the p-e was about 18, but interest rates on investment-grade debt were 2 percentage points higher than they are now. If an 8% drop from here is as bad as it gets, the market is relatively safe.

Safe Broad Market. Should there be a recession now, the threats to the economy wouldn't be as dire as they were in the past. "We don't have bank failures and we don't have war in the Middle East," says Edward Kerschner, global investment strategist at UBS Warburg. Instead, the market has the Federal Reserve's interest-rate cuts and President Bush's tax cuts rekindling the economy. The risk of a plunge in consumer spending is slight because unemployment and inflation are still low. And it's O.K. if business investment doesn't heat up again for a couple of years. "There is a point where capital spending stops going down and the remainder of the economy goes up, and it is called growth," says Kerschner. For example, pharmaceutical companies, retailers, and more service-oriented tech businesses will thrive. He's so confident, he predicts that by the end of 2002, the S&P 500 will reach 1835--50% higher than it is today. It's not as absurd as it sounds, Kerschner insists.

While the scale of Kerschner's 50% gain will likely prove wrong, the logic of his outlook is sound and shows the market is safer than its recent losses make it seem--except for tech stocks. Even after the Nasdaq collapse, the shares command 20% of the market's valuation yet represent only 10% of earnings per share of the S&P 500. Why? Because investors can't forget the stocks. Merrill's Bernstein laments that after he gives speeches describing great opportunities in other stock sectors, "we get to the Q&A, and the questions will be about tech, invariably."

The implication is clear: Tech stocks are still so glamorous that investors will pay too much for them. Even if tech earnings start turning up quickly, returns will be lousy because investors will keep overpaying for the stocks. The more investors support them, the more the industry will be plagued by too many competing companies and products, keeping pressure on prices and profits.

Tech earnings are declining so much that even if they bounce back 12% next year, as Salomon Smith Barney projects, they'll still be 40% below 2000 levels. Tobias M. Levkovich, a stock strategist at the firm, says tech profits won't be back to 2000 levels before 2004. That sounds like forever to bruised investors who bought the idea that revenues and earnings would keep growing dramatically. But it's actually optimistic: A profit recovery in 2004 would be half the time it took for the rebound from the tech earnings bust of the mid-1980s. "It doesn't take seven years anymore," says Levkovich.

If that's true, it's because the promise of the New Economy is real. Companies will use computers and telecommunications to enhance their productivity and earnings. They will buy the next generation of tech products if it enhances the bottom line. The problem for tech stock investors is the recovery probably won't be strong enough and soon enough to deliver a good return for holding the shares at current prices.

In the meantime, investors in nontech companies should benefit from the New Economy tools. The companies' earnings, and their stock prices, still swing--but not as far between highs and lows as before. Just-in-time inventory systems really do help companies avoid extreme overstocking to the ruin of earnings--a big reason recessions are coming once every 10 years, or less, instead of every four as in the past, says Kerschner.

Of course, corporate managers will still occasionally become blindly optimistic, misreading their orders and their customers' prospects and overexpanding. But recent examples have humbled executives and shown investors the danger of bidding up stocks as though the business cycle is dead. As long as memories of the bust last, the market should be able to deliver reasonable returns without unsustainable runups.


Copyright 2001 , by The McGraw-Hill Companies Inc. All rights reserved.