Are the Markets Taking a Little Snooze?

As everybody knows, the stock market took a dramatic turn for the better in March; right after it retested the October 2002 bottom in the major averages. Stocks dashed sharply higher, just as the number of folks bullish on stocks sank to a recent cycle low of 16%. It always works like that: The markets entice the greatest number of people to make the wrong decision just in time to inflict the maximum pain. There is nothing new about that. That maxim applied to the top in March 2000 when everyone was convinced that stocks could only go higher. And it applied in March 2003 when bonds seemed clearly to be the only port in the storm.

Think of all the people you know who threw in the towel last October, convinced that the only future path for stocks was down. They had been holding on for the turn, only to be disappointed repeatedly. Finally, they couldn't stand the pain of loss any longer and decided to radically modify their investment objectives. Instead of continuing to view the stock market as a means of generating good returns for their retirement plan, they reduced their hopes from making money to not losing it. They convinced themselves that bonds were a safe investment in which they might not make as much, but at least they wouldn't lose even more, even if that was an invalid assumption.

Wicked Turn

Investing in bonds as interest rates collapsed to 40-year lows was not a winning strategy. Many thought that at least they could just hold the bonds until they matured and not lose any money. The trouble with that logic is that there is absolute loss of principal and then there is what must be classified as opportunity cost (ie, what your money could be earning for you in an alternative investment). You also need to consider other factors, such as the need to be certain your principal is at least keeping up with inflation. If you're earning 2% on a bond and inflation is 4%, your purchasing power is eroding by the difference, or 2% per year. Right now, keeping money in a money market account that is paying less than 1% after fees is not sufficient to offset inflation, which currently appears to be running at about a 2% annual rate. That means that "money in the bank" is a losing proposition.

If you have been shopping for a new mortgage loan, you know that interest rates turned on a dime about a month ago. At the moment, rates for most categories of mortgages are 0.5% to 1% higher than they were in June. As the economy gives signs of improving, interest rates are likely to head much higher. When they do, yields on bonds will also rise. The flip side of that is that the value of the bonds will decline. If you decide that you don't want to own bonds in a rising interest rate environment, the logical conclusion is to sell them. Once you do, you will lose some of your principal.

Expecting Improvement

After a huge run-up in stock prices in the March to June period, we are now experiencing a sideways rest period in which the market is building a base for further advance. The market did not move straight down over the past 3 years, so it would be unreasonable to expect it to move straight up now. There are several factors indicating that money will continue to flow out of bonds and the trillions of dollars in money market and cash accounts and back into stocks. We finally have an economic package that has been passed by Congress. Payroll taxes have dropped enough for the average worker to notice. Other tax cuts in capital gains and dividends have also been enacted that will help the more affluent. Incentives are in place for corporations to purchase new technology with significant tax benefits to spur spending, even if modestly.

Most companies are comparing the economy with 2002's poor results, so any improvement will look good. In addition, the incredible talking heads on TV continue to warn that this is just another rally in a bear market. They still insist that price/earnings multiples are too high. Stocks are a better leading indicator of future earnings than almost any other measure. Stock prices turned down in 2000 when earnings still appeared to be rising endlessly. Stock prices have turned up now when the pessimists think earnings are not likely to recover soon (or ever). Notice, please, that fewer and fewer companies have been announcing earnings disappointments as 2003 has progressed.

Joan E. Lappin is president and CIO of NYC-based Gramercy Capital Mgt Corp, which has been top-rated in the Nelson's Directory of Registered Investment Advisors. Her investment outlook for 2003 was featured in the year-end BusinessWeek double issue. For questions, comments, or to attend an investment seminar, call 212-935-6909 or e-mail jlappin@gramercycapital.com.