What ails the stock market?

Does the stock market hate both war and peace? Nearly everyone had been saying stocks were depressed by war uncertainties that would vanish with victory, bringing a huge victory rally. Why didn't that happen?

Sure, it will take several months to get Iraq oil back on the market. Meanwhile, the U.S. government has unwisely decided not to fill that void with strategic reserves. Sure, there are still big uncertainties about the costs and dangers of occupation. But two of the biggest uncertainties have, in fact, been resolved -- namely, the duration and damage of war itself and the risk that Iraq's oil fields might be seriously damaged.

A new study available at nber.org, "What Do Financial Markets Think of War in Iraq?" concludes that "war lowers the value of U.S. equities by around 15 percent." Professors Leigh, Wolfers and Zitzewiz even offer lukewarm tips: "War is bad for consumer discretionary industries, airlines, finance and information technology." It seems to follow that winning the war should have raised U.S. stocks by 15 percent, but that hasn't happened. There was more involved than war jitters.

This is the third year in a row when pundits tried to blame weak stocks on touchy investor psychology. Last summer, the stock market was said to be depressed because previous corporate scandals had caused a loss of investor confidence. After President Bush got behind the Sarbanes-Oxley accounting bill, however, the Dow fell 400 points in two days. Stocks have yet to regain the level that existed before the government kindly offered to restore our confidence in federal regulation.

In 2001, the favorite theory was that the market was down because a bubble had burst. Stocks were down because they had been up. This is a remarkably unsophisticated theory of financial markets, which may explain its popularity at the International Monetary Fund. The IMF estimated that a $10 rise in oil prices would cut U.S. economic growth by 0.6 percent. Yet now that oil prices have fallen about $10, the IMF reduced its forecast of U.S. economic growth. Those who always insist on being gloomy about the United States naturally prefer psychological to logical explanations.

All recent efforts to explain low stock prices by mood swings are logically equivalent to asserting that corporate earnings are fine, it is just prices that are low. Whether they know it or not, those blaming low stock prices on attitudes and emotions are asserting that the ratio of stock prices to earnings (the p-e ratio) is much too low. That assumption is hidden, but not necessarily wrong. Bearish complaints that the p-e ratio is "above its historical average" are meaningless, because that is to be expected when interest rates are far below their historical average.

To find out if an unduly depressed p-e ratio is really the reason stocks are so cheap, it helps flip the price-earnings ratio upside down. Doing that makes the inverted earnings-price ratio comparable to an interest rate. For S&P 500 stocks, the resulting earnings-price ratio was 3.18 at the end of last year, based on earnings over the previous year. In 1999, when we were supposedly near the end of a huge bubble, the earnings yield was almost identical -- 3.17.

Since the relationship between stock prices and earnings was unchanged, the entire drop in S&P 500 stocks since 1999 was due to lower earnings. There is nothing left to explain. That casts considerable doubt on the notion that there was some inexplicable "bubble" in 1999 (aside from NASDAQ).

Interest rates, however, are lower today than in 1999. The e-p ratio is normally a shade below the yield on 10-year Treasuries, which dropped from 5.65 percent in 1999 to 4 percent at the end of last year. So the1999 market may have been a little too optimistic and/or the current market may be a little too pessimistic. Still, the psychology has not changed that much. What changed were earnings.

The only way to break that link between lower earnings and lower stock prices is to claim reported earnings are not exaggerated (as Congressional reformers claimed last year), but understated. And one way to justify that curious claim is to use the government's profit figures. By that measure, after-tax profits first fell from $542 billion in the fourth quarter of 1999 to $429 billion in the fourth quarter of 2001, but then rose 10 percent to $473 billion by the fourth quarter of 2002.

Such prominent economists as Alan Greenspan and Art Laffer have suggested these government's profit figures are more accurate than corporate reports. The Commerce Department subtracts the actual cost of exercised employee stock options from profits, for example, and adds it to employee pay. Accurate of not, federal profit estimates tell us nothing about the earnings that matter for stocks. Federal figures cover nearly 6,000 corporations (including farms) -- few of which have publicly traded stock. And, as the study mentioned earlier pointed out, "publicly traded firms tend to be more cyclically sensitive than others."

Putting undue emphasis on investor psychology allows both optimists and pessimists to say investors are nuts. To say the market is grossly undervalued today or that it was irrationally exuberant in 1996 simply means anyone making such statements claims to be wiser than the rest of us. It may seem easy to assert that investors are an irrational, moody bunch, making foolish investment decisions for foolish reasons. But the evidence says markets are wise and it is the second-guessers who are nuts.

Earnings for the S&P 500 peaked at 13.74 cents a share on March 31, 2000. At the end of last year, earnings per share were down to 3.41 cents a share -- a drop of 75 percent from the peak, even though the S&P index was down "only" 41 percent. The fourth quarter was likely a fluke, with war risks pushing energy costs up and profits down. Unit costs of labor rose 3.8 percent while prices rose only 1.2 percent. Companies will produce and hire more when it becomes profitable to do so. Then stocks will rise.

What ails the stock market? .. Wall Street that's who. They can't seem to get their heads out long enough to there is light at the end of the tunnel. I would love to move some money out of safe accounts and invest more, but I'm waiting for Wall street to chill it's nerves a bit .. they are all over the place.

Absolutely. A lot of people lost a lot of money the past few years, with the technology bust and the funny bookkeeping. Does "Wall Street" really think John Q. Public thinks that the game is fair now, that we can trust the numbers, that there is no insider advantage?

Baby boomers are closing in on retirement, and will have to accumulate safe money for the future. Add to that equation the massive numbers of good-paying jobs that have been lost, and the concern that those who have good jobs have about their security.

I'll be contrarian here. The low interest rates on CD's aren't helping people want to invest in stocks. It takes more money in those CD's to get the amount of interest they'll collect up to what they want.

Here's another concern...isn't anyone concerned about insurance companies, when they have to start paying out on large numbers of annuities and if there should be a disease factor increasing the death rate?

It's going to be a long, long time before people forget the recent stock market losses and the hype they were fed to not cash out during the decline. I look at my mother's generation...a lot of them never trusted the stock market again after the '30s.

"It's going to be a long, long time before people forget the recent stock market losses and the hype they were fed to not cash out during the decline. I look at my mother's generation...a lot of them never trusted the stock market again after the '30s."

The author does not seem to believe that the burst dot.com bubble or the corporate scandals have a bearing on the current market. In that, I believe he is very wrong. To me, those things, coupled with one of the highest federal tax bites in American history, and the recent fear of terrorism and war, are having a real effect.

Combine these things with the unwelcome bath most took in the market during the last few years, it's pretty understandable that many have not rushed back into the market.

Until we see proof of a change in government to punish the corruption we've seen in corporate America, private investors will hang back. The public got robbed, big time, and the government now protects the obvious theives. A shoplifter will be punished more severly than the corporate officers who lied to and stole billions from their 'investors'.

Capitalism depends on strict, verifiable and enforced fidelity. The corporate executives running companies large and small in this country are acting like a bunch of mobsters. There is little evidence to engender investors' trust. There is much evidence to foster the contrary. Corporate executives are openly walking away with tens of millions, while running their companies into the ground. They dont give a damn. And there is no penalty for these men when they commit fraud to steal all the substance from the companies they 'run'.

There was a short period of hope when we were treated to some perp walks, but that faded when we saw the big crooks continue their lives of luxury, untroubled by the distress of the victims or the two-inch arm of the law. So howcome the RICO statutes are not being used to get the obvious perps?

The marquee is glaring: "Want to get robbed? Invest in corporate America!"

People are merely taking notice!

In other words... "Buy on the bad news and sell on the good," right?

Well these days, after CNN confesses to screwing with the news to whore after a despot and we find Walter Chronkite narrating a PBS show called "Avoiding Armeggon," what's a contrarian to do? Plus Chronkite should never have been "the most trusted man in America!"

I think the market is filled less with sentimental types and more with "oblivious to the obvious" types, these days!!!

"The breather the other day was healthy"

I've always like your rather astute market comments. Are you a Financial Professional?

That Pooplava daily thread is always predictably negative on a perpetual basis. You don't seem to fit in with his fans and that's good, in my humble opinion.

That one is easy.

1. Confidence of "the average guy" in the markets is gone. He'd rather spend it than invest it and watch it dwindle.

2. The guys who stupidly managed the big pensions and funds during the boom are still in place, and are gunshy. They're still spooked over what to do.

3. Excessive compensation and perks to top management in the face of losses aren't inspiring confidence.

Stock prices go up for only two reasons:

A)a Company is able to produce a good that the public wants and is able to maintain pricing power over that product. i.e. there are legitimate barriers to entry in that market, that cost competitors dearly to get in. Investors generally like these stocks because they show ever increasing earnings, and in most cases spin off enough cash to actually pay a dividend. Example:Exxon has tremendous infrastructure to produce oil, it is very hard to get into that business, and oil is a needed product.

B) Stock prices also go up if "Wall Street" and of course your corner stockbroker can hype you on stocks as a way to get rich, make the big score, retire early, etc. If Wall Street can get enough people jacked up on a stock or stocks, then the demand outstrips the supply, running prices up. This is what we saw in 1998-2000. Too many people crazily chasing to few stocks. The stock market was no different than the beany-baby hype of 5 years ago. The concept is identical.

Right now because of a slow economy (it happens, things run in cycles) and foreign competition, solid companies are having a hard time implementing pricing power to produce significant profits (hence causing their stock prices to rise)

As to factor B, with corporate scandals and the market falling off a cliff, people aren't interested in stocks right now, so there is too little demand and way too much supply of stocks.

IMHO, the market crash has turned off a generation to stock investing, so big run-ups in the market may not return for 5-10 years. We need to solve foreign competition and get the economy rolling again to at least modest stock growth (5-10% a year appreciation)

Until we see proof of a change in government to punish the corruption we've seen in corporate America, private investors will hang back.

Something that is going unnoticed is the irresponsibility of those hawking mutual funds and playing the stock market to people who have neither the brains nor the knowledge to be there.

When I opened my trading account, I got lectured, insulted, by a twerp who said I should put my real savings in a trading account or mutual funds because FDIC insured stuff just doesn't pay enough. When I said I was opening the account for trading knowledge, kind of like a kid playing Monopoly and learning from my mistakes, he got really, really agitated.

Well, so did I. When I questioned him, he didn't know the rule of 72, he couldn't tell me how to actually find a PE or Beta on my own, and got it wrong when I asked him if a stock that goes up 10% one day and down 10% the next would break even (answer: no. Fluctuation is nasty to the bottom line, unless it's skewed upward).

I mean, the guy was an idiot. I complained, but he's still collecting the bucks. Bottom line...my fun account is still fun, and I pulled out the original investment, so I can't lose money.

But there are people who believed "experts" like this. Those people are broke. I wish they could claim the Porsches and mini-mansions these people got off other's misery and susceptibility.

I am no expert, just your average Joe. The stock market is kind of like gambling .. sometimes you win and sometimes you lose. Folks need to realize this before they jump into the pool and prepare themselves for the worse. Personally I didn't get caught up in the dot.com bubble because I had trouble understanding why folks would invest loads of money and not expect a company to make any kind of profit ... but that's just my opinion.

I too lost money .. but it was a paper loss and since the companies didn't go out of business, I do expect those stocks to go up eventually in time.

As for the cooked books, most of it is out in the open now and most of these companies know they are being watched and won't likly cook those books like they did in the 90's. and if they do, they deserve to get hit hard by the SEC

I have no problem jumping back in the waters of the Stock market again, but right now Wall Street is a bunch of nillie willies that need to chill out a bit .. but again, that is just my opinion ..

What about the big assumptions companies are making about projected earnings in pension funds? They add this imaginary income to the earnings they report. Verizon, Eastman Kodak, Northrop Grumman, Weyerhaeuser, Boeing, etc.

What about the dilution effect of stock options, and the reduction of earnings should granted stock options be expensed?

What about the self-dealing being done by the financing arms of companies - some are effectively buying their own products, and booking a profit?

These things are "out in the open" as you say - but the "experts" can mislead the public by manipulating the books to create an impression of financial soundness by covering up the real rot.

Lots of funny financial games are being played by most of the companies (and government) in this country. Every once in a while the music stops, and another class of investor is left holding the bag...

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