No More Bull?
The stock market is showing signs of wear and tear. It's time to play defense
For investors who came of age in the rip-roaring '90s, the long, frustrating years that followed the bursting of the Internet bubble have been marked by one tough lesson after another.
Investors found out the hard way in early 2000 that stocks can lose money. And they discovered during the bear market years of 2001 and 2002 that stocks aren't the only investments that can make real money, as housing prices shot through the roof.
Now, a little more than five years after the stock market peak of March 2000, folks who have been frantically trying to make up for lost ground are learning something new: Bull markets don't always have long runs, as they did in the 1980s and 1990s. "Investors have a misconception--possibly a dangerous misconception--that bull markets last six or seven years or more," says Jim Stack, editor of the InvesTech Market Analyst newsletter. Only three out of the past 15 bull markets have lasted five years or longer, with the average surviving only 3.4 years.
Yet even that's distorted by the longevity of the 1990s bull. The median length of a bull market--the statistical point where an equal number last longer or shorter--is only 2.6 years.
Guess what? The current bull market, which began in October 2002, is 2 1/2 years old. And it's showing its age. Since early March, the Dow Jones industrial average has fallen about 900 points on fears over inflation on the one hand and a softening economy on the other. Last week, a government report showed that orders for big-ticket items like cars and washing machines fell 2.8 percent in March, the biggest drop since September 2002. Add that to recent weak readings from surveys of consumer moods, and it's another sign that the almighty consumer is pulling back. So far, investors are following suit. "The risk premium in the market is rising," says Chris Orndorff, head of equity strategy for the asset management firm Payden & Rygel. "In other words, investors are becoming more aware of risks that they knew were there but had been a bit complacent about."
This is evident in the types of investments that have been hit hardest in the recent correction. Technology stock funds, for example, have been the worst performers so far this year, losing 12 percent of their value on average. Growth-oriented investments have also been rocked, as have industries such as online retailing, banking, and semiconductor manufacturing that follow the economic cycle. Meanwhile, companies considered defensive investments, such as healthcare--which do well in mediocre economies--have outperformed. This is a classic sign that the bull is in the sunset of its life. And here's the really bad news: "There's nothing you can do about the aging of the bull market," says Sam Stovall, chief investment strategist for Standard & Poor's.
But there are things investors can do to prepare for the transition. Start by throwing out every last vestige of new-economy think. Older bull markets require old school concepts--tried and true and, yes, boring: Save more, diversify, and learn some patience. "We got used to cheap, easy returns whether they were in stocks or other assets," says Colorado Springs, Colo., financial planner James Shambo. But going forward, he adds, "don't expect 10 percent annual returns in any asset."
That may even include housing. While the most recent report on new home sales showed them at a record level, the median price actually fell and sales are taking a little longer on average. Real estate is but the latest asset class, along with stocks, bonds, and gold, that has enjoyed a major run-up in the past two years and is considered by many to be either fully valued or overvalued today. The one exception: cash.
You just need to look at the numbers. Between 1980 and 2004, blue-chip stocks soared 13.5 percent a year. That's well above the 10.4 percent historic return for equities, despite the horrendous losses suffered in the 2000-2002 bear. That suggests a prolonged period of below-average performance. Strategists at U.S. Bancorp Asset Management, for example, expect average stock market returns to shrink to 7 percent annually over the next 25 years. Meanwhile, inflation has crept above a 3 percent annual rate, further cutting the real returns from stocks.
Lower returns mean one thing: Investors will have to save more money. Period. That's because there are basically two ways to create wealth: from gains on the capital you have already invested or from investing more capital. "If you don't have a lot of capital appreciation, then something's got to give," says Paul Kasriel, chief economist for Northern Trust.
The bull may not die a sudden, violent death. The economy continues to grow at a respectable 2.5 percent to 3.5 percent annual range, according to Bob Baur, managing director and global head of trading for Principal Global Investors. Moreover, while overall corporate profit growth is slowing, first-quarter S&P 500 profits have actually been coming in stronger than expected, says Mike Thompson, director of research for Thomson Financial. Still, there are some troubling signs. Investor confidence is waning. Half of all U.S. fund managers surveyed by Merrill Lynch in April believe the economy will weaken in the coming year, up from 15 percent in March. And nearly 1 in 3 fund managers now thinks the case for owning U.S. stocks is getting weaker. Then there's history. The market is halfway into its third year of rally mode, and third years tend not to be so good, often foreshadowing a full-fledged bear market. Moreover, both the Dow and S&P lost ground in January. Market lore says that as January goes, so goes the whole year.
And finally there's this to chew on: Despite the recent sell-off, stocks in the S&P 500 are trading at 19.5 times their trailing 12-month earnings. S&P's Stovall studied market peaks going back to 1946. The average price-earnings ratio of the markets at those moments was--you guessed it--19.5. "It's not a good sign," he says.
For investors, this means it is a tricky time and one in which you may want to play defense as much as offense. Here are some suggestions for how to do just that:
Be Patient. The biggest mistake you can make is following every to and fro in the market. A recent study by the consulting firm Dalbar showed that stock fund investors--who are notorious for underperforming the overall market--beat the S&P 500 last year. How? By hanging on to their stock funds longer. The average holding period for stock funds in 2004 was 4.2 years. That's up more than a full year from the holding period of the 1990s. And while you're at it, choose mutual funds that have low expenses.
Diversify. It may seem counterintuitive in a market where every asset class looks expensive, but the markets continue to confound conventional wisdom. The so-called smart money predicted that long-term interest rates would soar once the Federal Reserve Board began hiking short-term rates. Yet the Fed has pushed short rates higher seven times since last summer. Since then, the yield on 10-year treasuries has actually fallen from 4.62 percent to 4.27 percent. Investors who moved out of bonds missed out on the 11.1 percent (and stocklike) returns of long-term government bonds over the past year. The S&P 500, meanwhile, rose 3.4 percent. "Failure to be disciplined will put the investor at risk, especially in an unpredictable market like this," says Michael Cuggino, fund manager for the Permanent Portfolio, which invests in a mix of stocks, bonds, real estate, commodities, and foreign holdings. Cuggino's fund is down only 1.6 percent year to date, versus a loss of 4.2 percent for the S&P.
Place your bets. While you don't want to change directions every time the market takes a dive, it does pay to adjust your holdings according to the overall direction of the economy. This may not be the time to plunge into economically sensitive holdings like technology stocks. Instead, you might want to emphasize more defensive stocks, such as those in the healthcare and consumer staples sectors, which includes blue-chip companies like Procter & Gamble that make things like shampoo and bandages that people use all year round.
Seek Out Dividends. Joseph Quinlan, chief market strategist at Bank of America's Investment Strategies Group, favors large companies that pay dividends. "Corporations are flush with cash now," Quinlan says. So even if they run into short-term problems, "dividend payers have the ability to generate income and total returns for investors."
When stocks gained nearly 30 percent a year--as they did in 2003--a dividend yield of around 2 percent seemed insignificant. But with stocks perhaps gaining only 7 percent or less, 2 percentage points can be huge. Indeed, while domestic stock funds have returned 5.6 percent on average over the past year, those with dividend yields of at least 2 percent have gained 9.5 percent.
Broaden Your Horizons. The world is getting smaller. Not physically but in terms of global business. The United States is no longer the dominant economy it was 20 years ago. India and China are developing huge consumer classes, while European firms are global leaders in pharmaceuticals, energy, and retailing. "It's going to be very important to be diversified geographically," says Jerome Jacobs, senior investment strategist with Putnam Investments. A weakening dollar also will boost foreign holdings.
Admittedly, none of these ideas is as sexy as plowing your money into nanotechnology. But that's how you invest in an aging bull market. "It sounds really boring, but you just have to pick your strategy, persevere, and take what the market gives you," says Brian Jones, a financial planner with the firm Cooper, Jones & McLeland. "I wish I could tell you something more."
The Ugly
Total returns on most stock and bond funds have been negative so far this year.
Gold & Silver Index* -15.9 pct.
Nasdaq -8.1 pct.
S&P 500 -4.2 pct.
Real estate funds -3.0 pct.
Taxable bond funds -0.1 pct.
Money market funds 0.5 pct.
Note: Returns through April 27
*Philadelphia Stock Exchange
Sources: Morningstar, iMoneyNet, Yahoo!
This story appears in the May 9, 2005 print edition of U.S. News & World Report.