A New Era For Stocks

Damage at home. American wealth declined by $11 trillion in 2008, and if we feel poorer for long, it will be a problem for stocks. Future equity gains are closely tied to the health of the U.S. consumer. For years, that was a good thing. Floating on that same wave of stability, unprecedented access to credit, and booming prices for major assets (stocks in the '90s, homes in this decade), the phrase "Don't bet against the American consumer" became something of a mantra for many investors despite stagnant wages and soaring levels of household debt. At its peak, consumer spending soared to nearly 71 percent of GDP. Now many Americans are simply tapped out. Their recovery will be a big factor in determining when stocks will rebound. Unfortunately, consumer spending is closely tied to jobs, and once spiking unemployment reverses, some worry that those lost jobs may not come back. Recently, former Federal Reserve Chairman Paul Volcker warned of an extended "Great Recession" in which lost jobs in finance or the auto sector are not replaced, boosting the "natural" unemployment rate above the level of joblessness considered "full" employment today (about 5 percent) to something substantially higher.

At the same time, the financial crisis rages on. "Stress tests," bailouts, and executive bonuses still regularly top the financial pages, and the ultimate sign of success—normalized lending—is still probably a ways off. So, when might the financial crisis ease up? Not soon, according to research by Harvard's Kenneth Rogoff and University of Maryland economist Carmen Reinhart. They estimate a full recovery to pre-crisis levels could take four years. Stocks often rebound before a recovery gets going, but this time other challenges remain. The problem could be prolonged by the aftermath of huge amounts of debt. "There is a debt overhang problem that we haven't solved here," Reinhart says. "I see it as a lasting damper on equity markets. It is in the financial companies, it is in the households, and it will be in the government."

They estimate the government deficit could increase by $8.5 trillion over the next three years, and Reinhart warns that such spending, when combined with billions more being spent around the globe on stimulus packages, could spur higher taxes and renewed inflation, which eats away at all manner of investment gains and produces historically poor returns for stocks. Looking ahead, she warns that the damage from our banking crisis that rippled around the world could come sloshing back if eroding emerging market economies face banking crises of their own.

Reasons not to love stocks (as much). Wall Street trouble always brings out the bears, but this time the pessimists are getting more of a hearing, including those who think the current weakness in stocks is just getting started. Martin Weiss, author of The Ultimate Depression Survival Guide, advises investors to abandon stocks altogether. Other longtime bears like Jeremy Grantham say subpar market returns could last a biblical seven years as consumers and businesses reckon with a long-lasting debt overhang. The long-term value of slavish devotion to holding shares is being debated as well. A much-discussed paper published by Robert Arnott of Research Affiliates challenges the assumption that the "risk premium" that comes with stocks may be slimmer than many investors believe.

The other two key parts of a healthy market—dividends and earnings—also look a bit unappealing. During the '20s and '30s, dividend yields averaged 5 percent to 9 percent. They are much less generous now. The current 12-month dividend on the S&P is just 3.42 percent, which is below its historical average, and dividend payouts are expected to fall through 2010. And while first-quarter earnings were indeed better than many analysts expected, often gains came from cost cutting (including job reductions) rather than meaningful revenue growth. In an average recession, Citigroup says, global earnings historically fall 25 percent from peak to trough. As of April, earnings had already passed that mark with a 29 percent drop, but the severity of this downturn could push global earnings down by 50 percent. If markets do moderate for a long time, companies will be forced, at the very least, to come to terms with less access to capital. Start-ups entering the market with lucrative initial public offerings dried up almost entirely this year, and they are unlikely to return to lofty levels soon. Liquidity may have returned to precrisis levels by some measures, but the sort of lending that spurs outsize growth is still a ways off. "Companies have historically thrived thanks to cheap credit. Because that's been taken out, we have to expect more modest returns from equities," says Matt Rubin, director of investment strategy at wealth adviser Neuberger Berman.