CONSULTANT'S CORNER
The Bear Market in Perspective

By Bob Caplan and Peter LaBella

After nearly two decades of extraordinary returns, Wall Street has entered its first “bear market” since the summer of 1990. Compared to the peaks of a year ago, the S&P 500 Index indicates a decline in stock values of over 29% through the end of March 2001. The standard indicator of a bear market is a 20% decline. Stocks generally rise and fall with the business cycle, in response to the expansion and contraction in economic output, corporate earnings and cash flow. It’s not surprising that the spectacular bull market of the past decade was accompanied by the longest economic expansion in American history. During this time, corporate earnings expanded at a growth rate of nearly twice their long-term trend.

The current business cycle has now stagnated. A cyclical slowdown typically involves either a sharp slowdown in economic growth or a decline in the Gross Domestic Product — a condition classified as recession. During a slowdown, corporate earnings and cash flow decline, while corporate financial risk increases. Since corporate earnings often determine valuation of common stocks, it’s not surprising that the current weakness in corporate profits has been accompanied by a market sell-off.

The decline in stock prices has also been amplified by a shift in investor psychology. The simple reason is that stock prices reflect the eternal human struggle between greed and fear. Investor euphoria during the past five years reached exceptionally high levels, pushing stocks to overvaluation in a longer-term context.

There are numerous reasons why this overvaluation persisted, including: the unprecedented period of economic prosperity; the rapid pace of technological innovation; and the previous extended period of above-average stock market returns. Both Wall Street and the media proclaimed a “New Economy” in order to justify these higher valuations. This extended period of spectacular returns had a perpetuating effect, creating a mistaken impression that stocks provide high returns with low risk. The key point is that equity valuations reached unjustified heights during 1999 and early 2000. In the process, this magnified the vulnerability of equity prices to a reversal in fundamental business cycle forces. This dramatic shift in investor psychology has contributed to the sharp decline in the equity markets during the past year, as greed has shifted to fear.

The Fed

Probably the most important factor for optimism regarding the reversal in business activity and a recovery in stock prices is the Federal Reserve. During the 1999-2000 period, the Fed tightened monetary conditions and raised short-term interest rates by 1.75% to slow inflation. The impact of this was both economic slowdown and stock market decline.

The Fed shifted to a policy of monetary ease in early January 2001. Interest rates have been lowered by 2.5% to date, with more rate cuts likely in the coming months. Because shifts in Fed policy take roughly 6-12 months to fully impact economic activity, a revival is not anticipated until the second half of this year. As a result, corporate profits are vulnerable to further weakness during the next few months - and along with them — the equity market. The Fed’s goal is to avoid a recession and achieve a recovery in economic growth. Historically, the equity market has always anticipated these economic reversals in advance.

Although we cannot predict the direction of stock prices, the following observations may help you evaluate the outlook for the domestic equity market:

The significant decline in equity prices during the past year has eliminated much of the valuation risk that existed in 1999 and early 2000.

The Fed’s easing of monetary conditions and further cuts in short-term interest rates should support equity market valuations.

Underlying long-range economic conditions appear favorable. Inflation is under excellent control and the U.S. dollar remains strong. The Federal Budget is currently in a record surplus position, private sector productivity has been increasing, and corporate sector returns on invested capital remain high. The continued rapid pace of technological innovation will continue to enhance productivity and raise living standards. Lastly, credit markets have strengthened in recent months, and the banking system is in good health.

While the odds favor a recovery in equity markets with attractive long-term rates of return, you must keep in mind that common stocks are risky investments. Short-term returns can be highly volatile. There’s simply no “free lunch.” Equities tend to offer superior long-term rates of return compared to high-grade bonds due to their higher probability of loss, plus a greater volatility in market prices and annual rates of return.

The present bear market conditions will probably cause the market to behave in a more rational manner for the next several years. With this return to rationality, basic company fundamentals and traditional valuations will once again become the critical determinants of stock market performance.

Bob Caplan and Peter LaBella are financial advisors with FMA Advisory Inc., 1631 N. Front St., Harrisburg.