The New World

By Bob Wood, MMNS

As I write this column in mid-December, investors are poised to gain from a rally that many, including me, have predicted. A rally now means a great deal to those whose investments have suffered declines in the average equity mutual funds. But anyone hoping this rally begins a long-term rise in U.S. stock prices may want to look at conditions a little further down the road.

I know that being bearish doesn’t win many fans among the crowds of investors who remain positioned for ever-rising markets. The hope peddled in our financial media is far more readily accepted than the bearish foreboding coming from those who, until now, have been dead right.

Hopeful predictions sell better than the more gloomy views emanating from the Bears or, as I prefer calling ourselves, the Realists, as we offer opinions about the future course of America’s markets and economy. Of course, those in the Bear camp are heartened by knowing that our investment portfolios and the investors we influence have fared relatively well during the past few months. For the most part, we have avoided the dreaded “Big Loss of 2008,” one of the most miserable times for investors since the 1930s.

So given how right we pessimists have been during such a depressing year for investors, it might be worth considering the road ahead as seen by Realists — with no axe to grind or products to sell.

First, as I have stressed over and over again for the past few years, the domestic stock market remains mired in a secular, long-term bear market. Such long-term market trends usually last about as long as the secular bull markets preceding them. That rule of thumb would give the current bear market in equities a run of about another eight years. Of course, a longer time duration is possible, if we note the example set by Japan’s Nikkei stock index.

On the other hand, long-term, durable stock market rallies typically begin when stocks are shunned by chastened investors who have lost much over several years. We saw that happen at the end of our last secular bear market, the one ending in 1982, when valuations reflected the negative mood of investors. At its current 18-times-trailing-earnings valuation, the S&P 500 shows no sign of reflecting investor pessimism in stock prices.

But, you may say, business could improve dramatically, boosting earnings and bringing those lofty valuations in line with expectations for long-term profit potential in stocks. Could it happen? It could, but, in short, I don’t expect it to happen that way. Here’s why.

We seem to be entering a whole new world of investing, where what happened in the past means almost nothing for today’s investors. Previously, we could rely on the expectation that, after a lull in economic activity referred to as ‘’recession,’’ consumers could resume spending for those things they had forgone during the contraction.

The problem with that hope today is that the average consumer is buried in debt, with offsetting assets like their homes and stock portfolios falling rapidly in value. Those consumers are feeling the so-called ‘’negative wealth effect’’ that curtails future spending.

An article in the December 12 issue of the Financial Times suggests that ‘’Recession will change buying patterns for a generation.’’ The piece focuses on the financial situation in the U.K., where the chief executive of a large grocery chain says, ‘’This won’t be a recession where it’s a blip and then people return to how they were. Anyone waiting for things to get back to normal is mad.’’

Aaking matters even worse in the U.S. is the employment picture. With massive job cuts set to continue, more than half a million workers lost their jobs in November alone. In the past, we could rest assured that unemployed workers would find new jobs and that their spending would resume in due time. But the problem now is that too many workers have nowhere to look for new jobs. Consider the auto workers losing jobs at G.M., Ford and Chrysler. Where will they find work with all three companies shedding jobs at the same time? Sure, they might apply at a domestic plant making Toyotas or Hondas, but can you imagine how many are waiting in line for an application at those plants, which are already fully staffed?

In the financial sector, Bank of America’s purchase of Merrill Lynch has resulted in many redundant workers. Plus, an announced cut of 30,000 workers came after the demise of Bear Stearns, Lehman Brothers and Washington Mutual. And Citigroup and Goldman Sachs are cutting workers, too, in an effort to remain viable. So where will those laid-off workers find another job, when the entire sector is conducting a historic downsizing?

Not just individuals are feeling the pain resulting from companies’ poor fiscal management and poor investment returns. Far bigger problems abound at the state level, where news seems to worsen by the week. In California, which is responsible for about 20% of all U.S. economic activity, the governor is warning about his state’s pending ‘’financial meltdown.’’

A combination of rising costs and falling tax revenues has helped cause a massive deficit in the state’s budget. What was a projected $2 billion shortfall for the current fiscal year has grown so quickly that estimates now predict a shortfall of about $42 billion by the end of 2010. Measures taken to alleviate the crisis include reduced spending for schools, power projects and levee repairs.

In other words, the state is falling apart and finding no money for improvements. It is only a matter of time before California legislators must raise taxes and cut essential services. How long will it be before the state’s situation returns to normal? But California is not alone. States such as Florida and Illinois are also wrestling with deficits far greater than anticipated only a few months earlier.

Yes, few investors appreciate hearing such dire forebodings about the prospects for future stock market returns. For many, a rebound is badly needed. Yet if more investors had paid attention to bearish arguments in past years, they might not be in such great need of a miracle.

While I am not suggesting that we won’t have market rises to take advantage of in future weeks or months, I believe that any rally will be fleeting, at best, and not enduring. And better markets for investing exist in countries abroad, considering their far superior economic fundamentals and stock valuations.

With the conditions mentioned, I see little hope for domestic markets in the foreseeable future. Perhaps the best thing U.S. investors could hope for is a market crash, which would take stocks down to an average price-to-earnings valuation that more adequately reflects the economic realities we now face.

Investors need to understand more fully the nature of secular bear markets and, as a result, simply avoid domestic stocks for years to come. Foreign economies appear to be where sustained growth will start. And with many of those stock markets showing better values than we see here, that’s where I would look.

It’s a new world for U.S. investors, and other parts of that world may well provide better places to risk your savings over the next few years. Don’t dwell on the past and how our stock markets always recovered in time. Look ahead to where the future is brighter and economic trends are stronger now.

Have a great week,
Bob

Bob Wood ChFC, CLU Yusuf Kadiwala. Registered Investment Advisors, KMA, Inc., invest@muslimobserver.com.