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Even 'Masters of the Universe' Can't Master the Market

No matter what gurus do, history argues for greater stock declines.

June 18, 2002|JAMES P. PINKERTON

So Arthur Andersen has been convicted, L. Dennis Kozlowski of Tyco has been indicted, Samuel Waksal of ImClone has been arrested and even his friend Martha Stewart has been embroiled in an insider-trading investigation. And now the Justice Department is examining Enron for criminality; it shouldn't be too hard to find something even more rotten in Houston. So what should one conclude about the stock- optioning, creative-accounting culture of today's corporations?

Is everyone a crook?

No doubt more legal violations will be found, but the average investor is more likely to be affected by the breaking of another rule: the reality of market history, the financial equivalent of the law of gravity. Put simply, investors have been getting away with murderous winnings in recent years, and such gains could never have continued. Indeed, the next few years could well see portfolios getting murdered instead.

On Aug. 12, 1982, the Dow Jones Industrial Average closed at 776.9. Over the next 19 years, the Dow went up by a factor of 14, closing at a peak of 11,175.8 on June 5, 2001. But already, gravity's pull was being felt.

In March 2001, investment strategist Mark Rostenko predicted that the then-temporary downward correction in the bull market was in fact the beginning of a bear market. He based his analysis on the price-to-earnings ratio of stocks in the Standard & Poor's 500. The historical P/E ratio since 1926, he noted, was 16; that is, share prices were 16 times the per-share earnings.

Fifteen months ago, when Rostenko was prophesying, the S&P P/E was 21, which is to say it was abnormally high. He noted that the two great bull markets of recent decades, 1949-1966 and 1982-2000, both began when the P/E ratio was between 7 and 8. So at a 21 P/E ratio, the market was bumping up against its historical peaks, not down against its historical troughs.

And so, Rostenko concluded, prospects for continued upward movement were dim.

What's happened since?

Stock prices have fallen, but earnings have fallen too, and so the P/E ratio remains at 21. By this reckoning, despite a positive blip on Monday, the market still has nowhere to go but down.

It's always possible, of course, that conditions will change for the better; productivity gains from information technology might, for example, pump up the profits and the market. Yet market jitters over war and terrorism seem to be canceling out that boon.

In fact, if stocks were to drift down to merely their historical average P/E ratio, the market would fall by another fourth.

So another pile of shoes still to drop are the Guccis worn by Wall Street "Masters of the Universe."

On the long bulling upward, idols of investment were worshiped, such as Peter Lynch of the Fidelity Magellan Fund or Abby Joseph Cohen of Goldman Sachs. But now comes the disillusioning reckoning.

Assets managed by Janus Capital, for example, jumped from $30 billion in 1995 to $330 billion in March 2000. Today, Janus' assets have shrunk to $159 billion.

And there's probably more such shrinkage ahead. Stagnant markets show a basic fallacy of investing, which is that most fund managers can't beat the overall performance of the market. Smart as money mavens might be, few can outsmart the globalized market. John Bogle, who beat the averages during his 50 years on Wall Street, calculates that over those five decades mutual funds lagged 1.8% per year behind the S&P index.

So what's the answer? According to Bogle, it's indexing.

That is, buy stocks or funds that mirror the market, and then sit tight as the market goes up and down.

Indexing doesn't leave much room for sages and seers, of course, but their aggregate stock-picking record hasn't justified much faith.

But what about Wall Street corruption? It's good that prosecutors will be nailing crooks, but it's doubtful that politicians will have much to offer, except red tape and press releases. Why? Because the top-down bureaucratic culture of Washington gives pols little feel for the risk-taking, corner-cutting nature of globally competitive hypercapitalism.

And meanwhile, for most Americans mindful of their financial future, the real problem is that the bull market of the '80s and '90s is over.

Government-imposed "reforms" won't make Wall Streeters smarter or investors richer, as the overpriced market moves back down to historically normal levels. Now if it really dips, who should be indicted?


James P. Pinkerton writes a column for Newsday in New York. E-mail:

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