Turns out there's a bright side to falling stock prices.
You know, the outlook for stocks improved a lot this year. If it had improved any more, I think I might have started looking for an IRA that allowed me to invest in Elvis memorabilia.
Funny place, the stock market. It's the only store in the world where the customers become unhappy when the merchandise goes on sale. The S&P 500 has been mostly falling for three years now (not that you really need reminding), and how has the investing public responded? Flows of money into stock mutual funds have gone from a flood to a trickle, with dramatic outflows when the market has done worst. This past July investors yanked a net $49 billion out of stock funds, according to Lipper Inc. Average folks have been buying high and selling low.
Clearly, average folks are foolish to behave that way. But I've been feeling pretty average myself lately, trying to keep my cool while watching my retirement funds melt away. I know we're supposed to be looking forward, not backward. But it's hard to see past those crooked CEOs (especially, perhaps, if you're an honest one) or through the fog of war. Meanwhile, valuing stock shares has become more confusing. Even with the bubble long since burst, P/E ratios are above their historic levels. It's enough to make us wonder whether we'd be better off bailing out of stocks altogether. How do we know the market won't take 25 years to regain its peak, as it did after the 1929 crash?
The short answer is, we don't know, not for sure. But I find there are still good reasons to favor stocks over bourbon decanters in the likeness of the King -- or even bonds. The reasons start with some big differences between now and the 1930s, including a more resilient financial system and smarter monetary policy. But the rationale goes beyond all that, to the workings of the market itself. Even when things were at their overvalued craziest during the past decade, some basic physics remained in effect. And although the rapid double-digit gains of the 1990s aren't coming back, the basic physics indicates that diversified long-term investors can still look forward to some reasonable single-digit returns.
Why? Let's go back to the improving outlook for stocks. On a gut level, we can see that cheaper stocks have more room to grow. But to confirm that, we need a familiar financial yardstick called "expected return" -- and also some help from Thomas K. Philips, the scholarly chief investment officer at Paradigm Asset Management in New York City, who recently proposed an improved method for calculating that figure.
Expected return on a stock is analogous to the interest rate on a bond. The price of a stock, of course, is the net present value that investors assign to its future free cash flows. In the Roaring Nineties, that value soared. (Indeed, by March 2000, 6 out of the top 20 most valuable U.S. companies had P/Es of more than 100.) By paying more for future earnings, investors were expecting a smaller return on their investment -- whether they realized it or not. Expected returns fell pretty steadily in the bull market, from 10.5% in 1992 to 7% in 2000, says Philips.
Ah, but what about the productivity gains we were reaping from all our new technology? Weren't they going to send corporate profits into the stratosphere and justify those stock prices? No such luck. "It's a dirty little secret of capitalism that most of the benefits from productivity gains go to corporate employees and consumers, not to capital," says Philips. "Look at all those McMansions out there." In fact, as Warren Buffett observed in a 2001 Fortune essay, the ratio of corporate profits to nominal gross domestic product is roughly constant and rarely goes above 6.5%.
But take heart. The fact that corporate profits grow in line with the economy (rather than to the sky) is no disaster. It could even make you feel better about the index-fund shares you bought in 2000. Since expected return is roughly equal to actual return over very long periods, you should get your 7%, compounded annually from your purchase price, in 30 years. That's not a wonderful return on an equity investment, but it's not a stick in the eye, either. And because of falling stock prices, the expected return on the S&P 500 for the next 30 years is about 8.2%.
There remains the problem of those elevated P/Es. Can we be comfortable with them? Jeremy Siegel, Wharton professor and author of Stocks for the Long Run, says we can. Siegel makes the case that lower transaction costs and broader participation in the stock market and other factors have produced a permanent boost in the market's P/E, from around 15 to the low 20s. Check out Siegel's reasoning for yourself at www.jeremysiegel.com. While you're on- line, read what Thomas Philips has to say, at www.ssrn.com.
And remember: you've been making those long-term investments for the long term. Keep making them, month after month -- fortified with the knowledge that, relatively speaking, the shares you bought this year have been a bargain.
Financial writer Kenneth Klee -- who doesn't scare easily -- remains in the game.
The bear market has shaken some people's faith in index funds, which aim to simply match the performance of a stock-market index. But the funds remain hugely popular -- and a good way to benefit from the long-term rise in stock prices tied to economic growth. The biggest index fund, Vanguard's 500 Index Fund (ticker symbol VFINX), tracks the S&P 500, but that index has lately taken flak for a supposed overemphasis on tech stocks. For more diversification, consider tracking the Wilshire 5000 with Fidelity's Spartan Total Market Index Fund (ticker symbol FSTMX).