With a little luck, the economy and the stock market should hit bottom sometime this year. In fact, there's a chance that both already have, although it certainly doesn't feel like it. It will be a pleasant moment when we begin to bid farewell to the housing and credit busts, the banking meltdown, and frightened consumers—all sources of fear that kept Wall Street stomping on the "sell" button. What emerges next, however, is anything but certain.
Undoubtedly, post-bust Wall Street will look very different than it did after previous recessions. Chastened by regulators and stripped of long-standing opportunities for leverage, American companies, which have long been revered as the world's greatest profit engine, could be facing a prolonged stretch of tough times. Many analysts warn that long-term equity returns—the sort touted by financial advisers and analysts as an almost sure thing for much of the past two decades—could be based on outdated assumptions about the earning power of investing's most prestigious clubs: the Dow, the Nasdaq, and the S&P 500. "I would argue that we no longer have the kind of euphoria that caused the stock market to do as well as it did in the previous 20 to 30 years," says Andrew Lo, an economist at the Massachusetts Institute of Technology and a hedge fund founder. "We've experienced a rather dramatic shock and significant loss that has taken the steam out of [stocks]."
That means lots of rethinking will be required by all manner of market participants—companies trying to raise capital, investors planning retirements, pension funds facing large payouts—along with some difficult choices in a world where the search for a decent yield seems to get harder by the day.
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Tech-bubble hangover. Today's terrible stock market gets blamed on reckless banks, the housing bust, and all sorts of headline-grabbing culprits, but some of its woes predate the latest series of crises. Think back to the extreme excesses of the dot-com bubble's peak in early 2000—a period when overwhelming speculative optimism allowed the stock market to climb higher and faster than at any time in modern history. The sheer scale of that run-up means that even after a "lost decade" of negative returns, equities may still not be cheap. Rather, they might still be working off a lengthy tech-bubble hangover. Consider the relative scope of this bear market so far. From the peak of the dot-com bubble in 2000, the S&P had declined 58 percent as of March, based on the monthly average of daily closes. That drop, which included the S&P's devilish low of 666, is still smaller than the declines during peak-to-trough bear markets that occurred from 1929 to 1932 and 1968 to 1982, when shares fell 81 percent and 63 percent, respectively.
Price-to-earnings ratios tell a similar tale: The historic monthly average P/E ratio, based on 10 years of earnings for the S&P 500, is 16.3. In April, the average fell to 15.1—cheaper than usual, but hardly a value when compared with other periods of severe market disruption. For example, at the nadir of the 1982 downturn, the ratio fell to 6.6. Since economic damage in this downturn is expected to be far worse than it was in the '80s, the market's value could still be quite high.
Globalization and an end to the "Great Moderation." Even before the market meltdown, worries that a quarter-century of economic stability might come to an end were beginning to surface. Starting in the mid-1980s, the United States enjoyed a long stretch of unparalleled productivity, low inflation, and tame market volatility, interrupted by only modest recessions. Economists dubbed it the "Great Moderation." An ensuing sense of calm bred increased risk-taking. As the cost of risk declined, financial institutions took more of it, opening themselves up to large-shocks risks that eventually appeared in the form of the credit bust. In the end, banks simply couldn't afford trillions of losses caused by outsized bets on derivatives (which were based on risky loans to thousands of American homeowners).
Globalization, for all its vast economic benefits, added a second wrinkle. As appetites for risk were rising in the United States, they were also spreading throughout the globe. An often overlooked feature of the past boom is that it was the first ever to rise and fall in a truly integrated global market. Optimists hoped traders from Singapore to Lisbon would spread risks and make markets more efficient. That did happen. But that interconnectedness also meant a far larger number of investors around the globe began operating on the same set of flawed assumptions (that U.S. housing prices don't fall, for example). In the end, global stock markets acted in tandem when financial turmoil hit, and many emerging market indexes fell even harder than their U.S. counterparts. In a 2004 speech, Federal Reserve Chairman Ben Bernanke, who was then a Fed governor, summed up the Great Moderation as a product of structural changes, better macroeconomic policy, and good luck. If that luck has run out, its demise could bring a return of higher volatility and lower asset prices.