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Market Analysts See Stocks Poised to Overcome Pessimism

There's no denying that the past few years have been brutal for equity investors. The Wilshire 5000 stock market index posted a total return of -11% in both 2000 and 2001, then dived another 26.6% in the first nine months of this year?despite strong evidence that the U.S. economy was rebounding in the first half. Yet the outlook for equity investors is brightening, according to Putnam Investments economist David Kelly and Tulane University finance professor Peter Ricchiuti.

Kelly attributes the stock market's ongoing slump during the first nine months of this year, despite positive economic news, to negative investor psychology. "All year long people have not been in the mood to buy stocks," Kelly says. "We've gone from irrational exuberance to irrational pessimism."

It's not hard to figure out why, either. Since sailing through the overly hyped Y2K "crisis" unscathed, investors have had to grapple with the implosion of the technology stock bubble; a bitterly divided presidential election; a recession; the September 11 terrorist attacks; and, most recently, a wave of high-profile accounting scandals at what had been some of world's most respected corporations. But the recession is over. The US economy advanced at a 5.0% annual rate in the first quarter of this year and a 1.3% rate in the second quarter. Kelly predicts that with continued economic growth investor psychology will change for the better, too. Meanwhile, rising business productivity, low interest rates, lower levels of capital equipment depreciation and an employer-friendly compensation environment should allow US corporations to report healthy profit growth next year, as typically happens in the year after a recession.

Investors willing to venture into the stock market will find prices?by at least one important measure? that are the cheapest they've been in 17 years. Kelly explains that at the beginning of the fourth quarter, the stock market was trading at 17 times corporate profits as calculated by the Commerce Department using raw data from corporate tax returns. Expressed the opposite way, the earnings yield on stocks (earnings to price ratio) was 5.94%. Historically, that stock market's earnings yield has closely tracked the yield on 10-year bonds, but lately the 10-year Treasury has only been yielding about 4.29%. The 165-basis-point gap between the two measures, Kelly reports, is the widest it has been since 1985 and a sign that stocks, by this measure at least, are cheap relative to bonds.

Ricchiuti, who also serves as assistant dean at Tulane's A.B. Freeman School of Business, agrees. He sees other signs that the stock market may be poised to advance. For starters, the market's behavior over the past two and a half years hasn't been as uniformly bad as market indices would suggest. In fact, Ricchiuti says, over the past 31 months more stocks actually rose in price than fell. But that didn't stop investor behavior during the summer from reflecting attitudes that typically prevail in the third and final stage of a bear market, when fear of deeper losses and recession become so worrisome that many investors simply give up on stocks, setting the stage for a rebound.

Kelly proclaims himself a strict proponent of maintaining a disciplined investment strategy and concluded his presentation by observing, "staying disciplined today means not being underweighted in equities." He adds: "I don't believe in efficient markets. In the short run, at least, markets are driven by emotion. Now more than ever is a time for people to be disciplined and diversified."

Kelly did concede that his bullish outlook could be clouded by at least two potentially disastrous developments - a war with Iraq, or another terrorist attack on the scale of what happened September 11, when hijacked jetliners downed the World Trade Center towers and crashed into the Pentagon. "I think the economy is strong," Kelly concludes, "but it's not invulnerable."

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