Predicting a 50% Drop

["Henry C.K. Liu" <hliu@xxxxxxxxxxxxxx>]

John Mauldin is president of Millennium Wave Advisors, LLC, a registered
investment advisor.  He has been kind enough to send me his newsletter
gratis, the latest issue is below:

I (Mauldin) have been meditating in the implications of a very important
new article in the AIMR Financial Analysts Journal. It is a lengthy and
devastating analysis of what investors should expect by way of returns
in the stock market over the next decade or so. I will do my best to
give you the highlights.

 Plus, there has been a lot of data which has serious implications for
my prediction of a Muddle Through Economy. I have been mulling over
where to start, and I think we will begin with the AIMR article by Bob
Arnot and Peter Bernstein. AIMR is a very mainstream organization of
analysts and economists and NOT prone to bearish sentiment. The fact
that this article is in this journal is significant.

 (Bernstien wrote a magnificent book on the history of risk called
Against the Gods which is extremely readable, even though the topic of
risk can be complex. The AIMR article is still password protected,
though as soon as it is publicly available, I will provide you with a
link.)

 Investor Expectations

 I have written in the past about investor expectations. Many individual
investors, based upon the past two decades, assume they can get 15% per
year in the future. Most major corporations assume their pension
 portfolios will grow 9-10% or more in the coming years. By the way,
these assumptions add to their projected corporate earnings. If their
pension portfolios grow at less that those rates, they will have to
re-state earnings downward and lower future estimates.

 A drop of only a few percent in stock market growth expectations can
lower future earnings estimates at many companies by as much as 10%. To
me, the AIMR article says you can bank on earnings estimates to be
dropped as a result of exuberant projections. You should check to see if
the stocks you own are making aggressive assumptions.

 How many times have you had a stock broker quote you the Ibbotson
Survey or something similar which shows the stock market growing 8% per
year over long periods of time? All you have to do is just keep the
faith and buy and hold. You should especially never sell their funds.

 Bernstein and Arnot show that this number is VERY misleading. If you
break it down, it shows you something entirely different.

 First, the largest component of stock market return, up until 1982, was
inflation. From 1802 to present, $100 would have grown to $700 million
if you assumed all dividends re-invested. However, if you take out
inflation, we are left with a still impressive $37 million. If you take
out dividends, however, you find that your $100 is only worth $2,099!

 Here's the kicker: in 1982, the stock portfolio would have been worth
only $400. The bulk of the growth, over 80% of current value, came in
the last 20 years.

 This data simply says that conventional wisdom which says equities get
most of their value from capital appreciation is false. It is based upon
recent experience, and a bubble mentality.


 Risk Premiums

 Conventional Wisdom says stocks yield a risk premium of 5% over bonds.
You can look at the returns of the last 75 years and demonstrate that
fact. But in 1926, when you looked at actual expectations, based upon
then current yields, the risk premium (that amount by which stocks were
expected to out-perform bonds) was only 1.4%. Investors in 1926 did not
expect to get 5% over bonds over the next 75 years.

 But they did. The question one has to ask is why did this happen and is
it likely to repeat itself?

 Bernstein and Arnot says the increase in returns was due to a series of
historical accidents. The first was a "decoupling" of yields from real
yields. By that they mean that the coming of inflation changed the way
in which bonds were valued. In essence, in 1926, and for years after
that, bond holders assumed no inflation. Bond-holders began to demand
more in order to compensate for the risk of inflation. In fact, real
returns on bonds were often negative after WW II. That means inflation
was higher than the
 yields on the bonds. That change in the way bonds were valued accounted
for almost 10% of the increase in the "risk premium" from 1926 to
present.

 Secondly, valuation multiples rose dramatically. From a level of 18
times dividends in 1926, we now see dividend multiples of over 70. This
means that a dollar of dividends is valued at over 4 times what it was
75 years ago. However, the entire increase has happened in just the last
17 years. Not coincidentally, this was when we had a bubble. This
accounts for over 1/3 of the increase in the risk premium.

 Why were investors willing to take so little risk premium for stocks
over bonds in 1926? Because they did not believe there was "0" risk in
living in America. There were still those who remembered the Civil War.
Four of the largest 15 stock markets in the world had completely
collapsed within recent memory, with many others coming close to
collapsing. The US was not the pre-eminent world power it has become the
last two decades. Historical accident number three is that investors
have become increasingly confident in America. This is a good thing, I
think, but how likely is it that we are going to grow even more
confident from where we are today. Using a rough analogy, let us say
that we have grown 4 times
 more confident in the future of America over the past 75 years in terms
of being confident in bonds and stocks. Is it likely we will grow
another 4 times? Thinking back from what the world looked like in 1926,
seeing where we have come and trying to extrapolate that sense of growth
in security into the future, it think it is very unlikely we will feel
significantly better in the future than we do today.

 Finally, regulatory reform has done much to increase returns in the
stock market. In the early parts of this century, management would
routinely vote themselves more stock if a company did well, diluting
current investors, and keeping rates of return low. This changed as
securities laws were introduced. This has been a very good thing, but is
not likely to be repeated.

 In short, the events which led to the significant increase in the value
of stocks over bonds were basically one time events, and not likely to
be repeated. It is very unlikely that this trend will continue. Yet that
is what would have to happen if the Dow were to get to 25,000 by 2010 as
some predict.

 If the risk premium reverts to more normal measures, then either the
stock market, or the bond market, or both, are in for some turmoil. (See
details below.)

 The authors show that earnings and dividend growth for the past two
centuries is far less than the forward earnings expectations most
analysts have today. Interestingly, this study uses a different way to
analyze earnings than the National Bureau of Economic Research that I
cited last year, but both conclude that total market earnings will not
grow faster than the economy.

 Let's look at some of their direct conclusions. This is a rather long
quote, but it is critical. If you grasp what they are saying, you could
save yourself a lot of investment grief over the coming decade.

 "The historical average equity risk premium, measured relative to
10-year government bonds as the risk premium investors might objectively
have expected on their equity investments, is about 2.4%, half what most
investors believe. The "normal" risk premium might well be a notch lower
than 2.4% because the 2.4% objective expectation preceded actual excess
returns for stocks relative to bonds that were nearly 100 bps higher, at
3.3% a year.

 "The current risk premium is approximately zero, and a sensible
expectation for the future real return for both stocks and bonds is
2-4%, far lower than the actuarial assumptions on which most investors
are
 basing their planning and spending."

 Predicting a 50% Drop

 Then we come to the meat of the matter:

 "On the hopeful side, because the "normal" level of the risk premium is
modest (2.4%or quite possibly less), current market valuations need not
return to levels that can deliver the 5% risk premium (excess return)
that the Ibbotson data would suggest. If reversion to the mean occurs,
then to restore a 2% risk premium, the difference between 2% and zero
still requires a near halving of stock valuations or a 2% drop in real
bond yields (or some combination of the two). Either scenario is a less
daunting picture
 than would be required to facilitate a reversion to a 5% risk premium.

 "Another possibility is that the modest difference between a 2.4%
normal risk premium and the negative risk premiums that have prevailed
in recent quarters permitted the recent bubble. Reversion to the mean
might not ever happen, in which case, we should see stocks sputter along
delivering bondlike returns, but at a higher risk than bonds, for a long
time to come."

 They then conclude, "The consensus that a normal risk premium is about
5% was shaped by deeply rooted naiveté in the investment community,
where most participants have a career span reaching no farther back than
the monumental 25-year bull market of 1975-1999. This kind of mind-set
is a mirror image of the attitudes of the chronically bearish veterans
of the 1930s. Today, investors are loathe to recall that the real total
returns on stocks were negative for most 10-year spans during the two
decades from 1963 to 1983 or that the excess return of stocks relative
to long bonds was negative as recently as the 10 years ended August
1993.

 "When reminded of such experiences, today's investors tend to retreat
behind the mantra "things will be different this time." No one can kneel
before the notion of the long run and at the same time deny that such
circumstances will occur in the decades ahead. Indeed, such crises are
more likely than most of us would like to believe. Investors greedy
enough or naive enough to expect a 5% risk premium and to substantially
overweight equities accordingly may well be doomed to deep
disappointments in the future as the realized risk premium falls far
below this inflated expectation."

 "Hopeful" Outcomes

 I smiled when I read their concept of a "hopeful" outcome. It gives a
new meaning to the word hopeful. Their view of hopeful is only a 50%
drop in the stock market or a dropping of long term rates to levels
which imply outright deflation. Or we would see a Muddle Through Market,
with stocks going sideways for many years.

 What could make their scenario wrong or irrelevant? They could be wrong
about earnings growth. Earnings could grow rapidly, and thus valuations
drop back to normal levels without the pain suggested in their study.
Many analysts think earnings are going to rebound dramatically in the
near future.

 However, my friend Gary Shilling points out in his recent newsletter
that this is not likely. For stock valuations simply to come back to the
mean, earnings would have to grow at 38% in 2002 and 38% in 2003 to get
back to an operating earnings P/E of 15.

 Shilling does a relatively straight-forward analysis to show that this
would mean a rise in the GDP of 13%, which he says appears patently
impossible. In order for such an event to happen, labor would have to be
willing to give back wages and consumers would have to be willing to pay
a LOT more for products. The Texas Rangers will be in the World Series
before these happen.

 In fact, the data shows that the economy is much more likely to grow
around 2.5% for the year. That is not bad, but it is not enough to help
corporate profits grow back to the levels forecast by Wall Street
analysts. Abbey Joseph Cohen still thinks the S&P 500 is going to 1300.
She is wrong.

 Dollar Merry-Go-Round

 All this has profound implications for the dollar. One of the hottest
and most interesting current debates among economists is about the value
of the dollar. Dollar bulls say that the rest of the world will continue
to buy our stocks, bonds and assets. Why should demand for the dollar
change? They have been right for a long time, as those who worry about
our trade deficit have been wrong in predicting a crash in the dollar.
Why should the next few years be any different than the past?

 For the record, I have been bullish on the dollar for many years, up
until recently. What has made me change my mind?

 The "current accounts deficit" is approaching critical mass. Think of
it this way. If you spend more than you make, you have to do something
to make up the difference. You can sell the furniture, borrow money,
hock the kids, get a second job and so on. If you do nothing, you will
soon be bankrupt.

 On a macro scale, it is not much different for governments and
currencies. We are buying more products from overseas than we sell. To
make up the difference, foreigners have bought our companies (called
mergers and acquisitions or M&A), bought our stocks and bonds and
sometimes bought
 our currency (in the form of bonds and t-bills).

 Much of the M&A has been from Europe. This has been drying up at an
alarming rate in the past few months (see below). It is almost like
Europeans smell blood, and realize they will be able to get the US
assets cheaper in the future if the dollar drops.

 The longer this stock market goes sideways, the less enthusiastic the
world will be with US equities. If you are not convinced the dollar is
going up, you will invest in your own currencies or in Euros.

 Morgan Stanley analysts Jen and Yilmaz point out that if the world
shifts from the current equity regime to a bond regime (their word) that
the dollar would go from being slightly over-valued to dropping by as
much as 15-20%.

 In other words, if Bernstein and Arnot are right and investors are
going to become increasingly interested in the absolute returns, then
the dollar is at real risk.

 And then one of my favorite analysts., Stephen Roach, weighs in with
these thought-provoking words:

 "Never before has the United States commenced economic recovery with a
current-account gap totaling 4% of its GDP. (They predict it will rise
to 6% in 2003, although Fed studies show that when the trade gap gets to
5%, serious problems will develop - JM) Given the high level of import
penetration now structurally embedded in the US economy -- with goods
imports at 30% of GDP in early 2002 -- another stretch of US-led global
growth will most assuredly result in a significant further widening of
the external shortfall.

 "If such a massive external funding requirement doesn't lead to a
saturation of the foreign appetite for US assets, I'm not sure what
will. Just because America's external financing was manageable in the
1990s
 doesn't mean it will be so as the as the ever-widening current-account
deficit now ups the ante on capital inflows. Needless to say, that
conclusion is in direct contradiction to that of the capital-flow-driven

 justification of the Bush Administration.

 "Interestingly enough, there are signs suggesting that this point of
saturation may now be at hand. As Joe Quinlan and Rebecca McCaughrin
have recently noted, the portfolio portion of capital inflows into the
United States has slowed dramatically in early 2002. Over the first two
months of this year, foreigners purchased just $27 billion of
dollar-denominated assets, a dramatic reduction from the $100 billion
pace in the first two months of 2001.

 "Meanwhile, foreign direct investment into the United States -- the
other major piece of the capital inflows equation -- has also slowed
dramatically. FDI into the US was $158 billion in 2001 -- only a little
more than half the $295 billion average pace of 1999 and 2000. Fully
two-thirds of this slowdown is traceable to diminished FDI activity from
Europe; that's largely a reflection of a dramatic downshift in the
cross-border M&A cycle -- a trend that has continued into the early
months of 2002.

 "I remain convinced that America's current-account deficit represents a
key point of tension for the US and global economy. It is the crux of
our "global decoupling" thesis -- that the world can no longer afford to
be dependent on the American growth engine as the dominant source of
economic growth. The coming US current-account adjustment speaks of a
new recipe for sustained global growth -- a slower pace in the US, a
speed-up elsewhere, and a weaker dollar. The logic of the Bush
Administration is flawed in the sense that it relies on an
ever-expanding stream of foreign inflows into dollar-denominated assets.
In this
 post-bubble era, that may well turn out to be the ultimate in wishful
thinking."

 The dollar is headed down, and perhaps the beginning of the drop is
sooner than I had previously thought. You can open foreign denominated
CDs in the Euro or other currencies at Everbank right here in the USA.
Just click here to view their information page.

 One of several things will have to happen over time. We will have to
decrease our purchase of foreign goods, although since so much is
manufactured overseas, this is not a short-term solution. Foreign
 purchase equal to 30% of GDP is huge.

 If the dollar drops, manufacturing and production will come back into
the country, as it will become cheaper to produce things here. Just as
we enjoy cheap foreign products, the drop in the dollar will make our
products cheaper in terms of foreign currencies, and so we will sell
more of them.

 The US will still be the premier world economy for some time (decades
and decades) to come, and foreign companies will want to have a presence
here, and will buy our companies and assets, which will help balance the
current accounts deficit.

 All these should keep the dollar from the crash that many predict, but
will not save it from the 20% drop that the Morgan Stanley analysts
predict. How soon will all this happen? I don't know, and neither does
anyone else. If I say in the next year or so, it is just a guess, and
that is my guess. Many analysts hazard a guess which they call a
prediction, in case they might be right. If they are, they will remind
you of the accuracy of their prediction. If not, they assume you will
forget.

 Muddle Through Still On Track

 There is lots of other data, like the new recent high in unemployment,
to suggest that we will Muddle Through this year. Muddle Through may be
the best we can hope for. Next week, we will look at much of the recent
studies and take a fresh look at bonds. High yields were good to us last
month, as my favorite high yield bond CGM posted some nice numbers. I
will also report on what I learned at the recent SAAFTI (Society of
Asset Allocators and Fund Timers, Inc.)

 John Mauldin
 JohnMauldin@xxxxxxxxxxxx

 Copyright 2002 John Mauldin. All Rights Reserved.