We're Halfway Back to the Top.

Pulling Ourselves Out of the Crash
We're Halfway Back to the Top. How Much Longer Till We Get There?


By Tomoeh Murakami Tse
Washington Post Staff Writer
Sunday, October 11, 2009

NEW YORK

As far as recovery goes, U.S. stocks appear to be halfway there.

Contrary to warnings by analysts that the market had gone up too much too fast, the rally that began in the spring only accelerated over the summer as investors took on more risk in both the stock and bond markets. The Standard & Poor's 500-stock index now stands at 1071, nearly 400 points above its recent low on March 9.

But the benchmark has almost 500 points to go before it recovers to its October 2007 high, making battered investors whole again.

The force of the surge in equities -- the S&P is up 58 percent since the March low -- came as investors grew more confident that the doomsday scenario of the nationalization of large banks and a prolonged global recession had been avoided. But with consumers hurting and unemployment high, expect the second leg of the healing journey to take much longer, experts say.

"I think we are entering into a period right now of 'Show me,' " said Robert Millen, chairman of Jensen Investment Management. "The market has bounced back dramatically. We're in a real critical period right now where the market's taking a breath and is now starting to pay more attention to fundamentals."

During the past eight recessions, Millen said, the S&P 500 took an average of 1.9 years to recover to the previous high. The fastest recovery time was 83 days, after the 1981-1982 downturn. The longest was 2,114 days, almost six years, after the recession in the mid-1970s.

Analysts will be closely watching the third-quarter corporate earnings results over the next several weeks for clues on just how long this recovery will take.

For his part, Millen says he thinks it could be at least 3 1/2 more years. Some bulls say it could happen sooner. But others say the recent rally is just another bubble in disguise -- not progress toward real recovery.

"We're seeing everything move up," said Axel Merk of Merk Mutual Funds and author of the book "Sustainable Wealth," due out this month. "But that's exactly what we saw in the pre-crisis. . . . Some investors are going to jump on the bandwagon because they want to be a part of this. But this has to have a bad ending."

During the quarter ended Sept. 30, the Dow Jones industrial average of 30 blue-chip stocks jumped 15 percent, to 9712. This is on top of an 11 percent gain in the second quarter. And on Friday, the Dow climbed to its high for 2009, gaining 78 points to hit 9865.

The S&P 500, a broader market measure, finished the third quarter up 15 percent, at 1057. Both benchmarks posted their best quarterly performance in more than a decade. The tech-heavy Nasdaq composite index rose 16 percent.

Leading the rally were the companies hit hardest during the financial crisis -- those with heavier debt, riskier balance sheets and inconsistent earnings. In the third quarter, shares of financial firms soared 25 percent; companies in the consumer discretionary sector -- think home builders, automakers, apparel manufacturers and hotel chains -- rose 19 percent. Defensive stocks in the utilities and consumer-staples sectors, meanwhile, turned in more modest gains of 5 and 10.5 percent, respectively.

According to Lipper, a mutual fund data company, funds that invest in financial services companies rose an average of 23 percent for the quarter. The best performers among sector funds were real estate funds. They returned nearly 33 percent after being hit hard in the downturn.


Mutual funds that invest in shares of small companies outperformed those that invest in more stable, larger companies. Value funds did better than growth funds as investors searched for undervalued shares. Large-cap growth funds returned 14 percent in the third quarter; small-cap value funds came in at 21 percent, Lipper said.


Funds that invest overseas fared even better. International large-cap growth funds returned 17 percent, while emerging-market funds gained 21 percent, Lipper said. Those that focus on Latin American companies were up 28 percent.

Investors also took on more risk in the credit markets. Here, funds that invest in high-yield junk bonds performed best, returning 13 percent for the quarter. Emerging-market debt funds also did well, gaining 11 percent. Meanwhile, short-term U.S. Treasury funds rose 0.8 percent. Longer-dated Treasury funds gained 4.7 percent, Lipper said.

"We're getting the typical market recovery in anticipation of the economy getting better -- and I think it will," said Mark Coffelt, chief investment officer of Empiric Funds, adding that he thinks the S&P could rise 100 to 150 points in the fourth quarter. Because they think the performance trends seen in stocks during the third quarter will continue for at least six more months, his team is looking for stocks of smaller companies that are selling cheaply, he said.

Still, Coffelt and others cautioned that it could be a slow and long recovery. Consumer spending, the main driver of the U.S. economy, is hardly expected to come roaring back, as consumers' job security is threatened and lines of credit are cut.

There is also worry that another shoe could drop. Speaking at a dinner in Manhattan on Tuesday honoring influential female bankers, Sheila C. Bair, head of the Federal Deposit Insurance Corp., said she was concerned about the commercial real estate industry and its impact on banks. "Commercial real estate is starting to eclipse mortgages" as the driver of bank losses, said Bair, who added that she expected bank failures to continue at a good clip into 2010.

Merk said stocks are overvalued and that the recent rally is a direct result of investors taking advantage of the easy money created by the Federal Reserve's fiscal policies. In response to the economic crisis, the Fed has reduced interest rates to near zero and flooded the market with money by buying up Treasurys and other assets.

"People are again yield-hungry," said Merk, 40, who added that he has no stocks in his personal portfolio. "They're going to grab anything that gives them a little bit more return than Treasurys that yield close to nothing. Rather than normalizing things where we would have slower growth but market-based returns, we have the Federal Reserve interfering in the markets artificially, depressing yields and encouraging exactly the sort of practices that got us into trouble in the first place. We haven't resolved the issues from the last crisis."

James Paulsen, the bullish chief investment strategist at Wells Capital Management, disagrees.

During the recent downturn, companies purged payroll and inventory, getting their operating costs down to "a place where they can survive the next coming of the Depression," he said. This, combined with profits generated from the economic recovery, will lead to "a whale of an earnings cycle."

"I still see a lot of potential here," he said. "I highly doubt that the markets are likely to peak a couple of months after the recession is over."

Companies in the S&P 500 were trading at 14.5 times their estimated earnings for the next 12 months, near the historical average of 15 times earnings, according to Thomson Reuters.

But bulls such as Paulsen argue that stocks' price-to-earnings ratio is not necessarily extended, citing favorable market conditions of below-average inflation and interest rates.

Jeff Mortimer, chief investment officer of Charles Schwab Investment Management, says it wouldn't be surprising to see the market pause or pull back 5 to 10 percent. Such moves are typical in the early stages of a bull market, which is where he says we are now.

So, what's a small investor to do?

Of course, the answer depends on an individual's risk tolerance, time horizon and outlook.

"I would be buying at points of weakness to add to my positions or get closer to my target asset allocation if I'm underweight equities," he said. "My recommendation would be to dollar-cost-average and get to your target allocation over the next six, 12, 18 months. You may find that the longer you wait, the higher the market gets. Then you're really in a pickle."

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