NEW YORK (MONEY Magazine) -
Little more than a week ago it seemed as if -- finally! -- the worst was behind us. Then the selling started again. Instead of rejoicing over the week's rally, investors are wondering how soon it will be before they give back all the gains.
That's because behind every rally the same scary questions linger. In the short term, after thinking we emerged from recession, are we now headed back down for a "double-dip?" Will the earnings slump and corporate scandals continue to hang over the market? And longer-term, can we still count on stocks to help us reach our financial goals?
In the latest issue of MONEY Magazine, the editors tackle dozens of such questions -- below are just five, beginning with the most important one:
When will the bear market end?
Indeed, every time it seems there's a bottom, the news keeps getting worse: The market could well be headed for its third straight losing year for the first for the first time since 1939-41.
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Also in this series...
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To think about when things will get better, you first have to wade through some of the bad news. Last week investors were treated to downward revisions of the GDP, plunging consumer confidence, and other indicators that showed weakness in the manufacturing sector.
But it's far from a foregone conclusion that the economy is headed back into recession. Interest rates are at their lowest level in years, and inflation remains in check. And while unemployment has been rising, it remains below 6 percent.
Corporate earnings? They bottomed out last year and are expected to bounce partway back this year. The newsletter Blue Chip Economic Indicators, which surveys economists to get a consensus outlook, forecasts annualized economic growth of 3.3 percent in the third quarter and 3.7 percent by the fourth -- strong numbers.
So what will it take to turn stocks around?
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Bear market help
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Amid the threat of terrorism and the accounting scandals, investors will need to get comfortable with investing again. And that will require a gradual accumulation of positive news on three fronts: clear signs that the market's continuing problems won't end up leading the economy into a double-dip recession; consistent earnings growth from major corporations; and, perhaps most important, signs from regulators, legislators and prosecutors that serious reforms will be put into place.
Is this the worst bear market ever?
In dollar terms, it is. Investors have lost more than $5.1 trillion in S&P 500 stocks alone since March 24, 2000. That's far more wealth than was wiped out in the crash of 1929. But in percentage terms, the crash of 1929 and subsequent decline, which dragged on until 1932, remains the champ, with the Dow Jones industrial average plunging 86 percent.
So far at least, here's how the current slump stacks up: The Nasdaq is down 75 percent below its peak; the S&P 500 is down 43 percent; and the Dow is off 32 percent.
Are stocks cheap now?
You would think that after months of brutal declines, many stocks would now be selling at bargain prices. But are stocks truly cheap? It depends on how you look at it.
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Mutual Funds
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The most common way of valuing stocks is the price/earnings ratio. Historically, the average P/E for the S&P 500 index has been about 16. At the bottom of the 1973-74 bear market, stocks sported a P/E of 7. Today the market trades at 19 times the latest 12 months' earnings. So the simple answer is that stocks are not cheap, despite the stunning decline in share prices.
But based on earnings projections for 2003, the P/E is just 15. And according to many analytical models, which take into account earnings and interest rates, stocks are undervalued by some 30 percent. The problem, of course, is that most investors don't trust the earnings component of valuation calculations.
Which stocks offer the best value?
In 1986 the market strategists at Merrill Lynch embarked on a quest for the stock picker's holy grail -- the one statistic that best predicts future stock returns. Their conclusion? The valuation metric most consistently predictive of high future returns is the one investors already know best: the price-to-earnings ratio.
Among the low-P/E stocks we like right now is Washington Mutual (WM: up $0.58 to $38.50, Research, Estimates); the nation's largest savings and loan was recently trading at $36 a share. Its P/E of around 9 puts it among the bottom 10 percent of the S&P 500 in terms of valuation, while its 35 percent earnings growth over the past four quarters places it in the S&P's top 15 percent for that category.
Another low-P/E stock we like is pharmaceuticals giant Merck (MRK: up $0.67 to $51.02, Research, Estimates), currently trading at $47.50 a share. Yes, Merck is going through a rough patch, but it has weathered down cycles before and, at 15.9 times earnings, the stock is the cheapest it has been since 1994. "It's not a very good story at the moment, but that's part of the art of buying things that are out of favor," says Bill Fries of Thornburg Value. "We see five or six drugs in development that could be billion-dollar products down the road."
Finally, there's John Hancock Financial (JHF: up $0.61 to $32.50, Research, Estimates). A P/E of 10.7, coupled with consistent double-digit earnings growth, makes the life insurer at $31 a share a conservative bet in a rough market. Better still, anti-takeover restrictions linked to Hancock's 2000 IPO are set to expire in January and, given its topnotch brand and solid fundamentals, a bidding war for Hancock is a real possibility.
What should I do with my 401(k)?
The average employee watched his or her 401(k) balance fall 11 percent in 2001 despite having made higher contributions than in 2000, according to Cerulli Associates of Boston. The closer you are to retirement, the more disturbing the losses. But whatever your age, there are steps you can take to repair the damage and get back on track.
STEP 1 Learn the Enron lesson: Reduce the amount of company stock in your 401(k) as much as company policy allows. No matter how optimistic (or gloomy) you feel about your employer's prospects, your retirement nest egg is too important to expose to the volatility of a single stock -- or even a single sector.
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Retirement tools
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STEP 2 Correct your allocations. Once upon a bull market you may have gleefully elected 100 percent equities or a heavy weighting in tech. Now it's clear that a mix of large-, mid- and small-cap funds, international stocks and bonds that's appropriate for your time horizon makes a lot more sense. Get into the habit of rebalancing at least once a year.
STEP 3 Adjust your expectations. If your goals were based on achieving returns of more than 10 percent, run some more conservative scenarios, assuming, say, 7 percent. You may have to increase your savings as a result, so be aware of new contribution limits going into effect -- $11,000 this year, increasing by $1,000 a year till 2006.
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