Just when everyone gave up onthe stock market in 2003, theaverages turned in a year that achamp would be proud of. A fewmonths ago, most investors had fullyembraced bonds, saying they would bethrilled with an 8% return on theirinvestments in the future. After 3 horribledown years (2000 to 2002), everybodywas extrapolating the downturninto infinity. For most investors, thefirst goal was to stop the pain of furtherlosses. Next was to purchase investmentsthat seemed like ironclad ways tonot lose money (ie, bonds). Those who took what was left of their401(k) and pension plans and movedthem to bonds between October 2002and March 2003 missed the opportunityto start restoring their nest egg in thestock market.
Whether it's betting on the Sundayfootball games or investing in the stockmarket, Monday morning quarterbackshave a perfect record of calling the rightplays. What puts you in the driver's seatis figuring out the right moves beforethe game is played, not after it's overand you're looking at the game tapes.
Prior to March 2003, the last timeinvestors were so decidedly lined up onone side of the bond/stock equation wasback in 1981 and 1982, when interestrates peaked. Bonds had been losingmoney for years, and by 1981, 85% ofinvestors were avoiding bonds at allcosts. What followed were two decadesin which bond prices moved higher asinterest rates fell lower. During theseyears you couldn't lose money in bonds.Even so, stocks were the better bet forall but a handful of those years.
Now, interest rates have fallen totheir lowest levels in 40 years. Dangerlurks on the other side. The FederalReserve has suppressed interest ratesthroughout this year to allow bothhomeowners and corporate executivesto repair their balance sheets. Companyafter company has refinanced its debtwith much lower interest rates. Corporationsservicing heavy debt loadshave been able to buy debt at cents onthe dollar and reduce interest costs substantially,adding to earnings per share.Companies like Nextel that faced creditdowngrades are now enjoying the oppositeevent, sending stocks soaring. Thisyear, homeowners who were fast to actwere able to refinance their homes atrates near 5% during the summermonths, improving their cash flow.
Lost Opportunity Cost
This year, the biggest penalty ofowning bonds was a paltry 2% returnon your 10-year Treasury holdings in aperiod when superior returns wereavailable in even the least exciting stockaverages. At the end of November, theDow was up 17.3% and the S&P 500had risen a respectable 20.3%. Mostgains occurred before there were clearsigns that the economy was improving.
This is why looking at price/earningsmultiples several months ago anddetermining that stocks were overvaluedwas an exercise in futility. We onlyknew the price part of the equation. Wehad no idea about corporate earningsand whether or when they would beginto rebound. All we knew for certainwas that for the past 100 years, ourstock markets and economy have goneup and down in cycles.Projections for 2004Eventually, what goes down mustcome up, and now it has. When the fedis comfortable that easy money and lowinterest rates are no longer needed tostimulate the US economy, interest rateswill rise. At that point, bonds will fall inprice as yields climb.
This past year was about opportunitycost (ie, the amount you might have madeholding stocks). Next year will be aboutactually losing money through bondholdings. Bond prices work inversely tointerest rates. They rise when rates arefalling and fall when rates are rising.
Remember that President Bush isseeking reelection in 2004. For that tohappen, the economy must be hummingalong in the fall of next year. The Bushadministration will do everything in itspower to make sure that the economy isimproving nicely when you go to thepolls next November.
Joan E. Lappin is the chairmanand chief investment officer ofGramercy Capital Management inNew York City. She will be featuredin the year-end Business-Week on "How to Invest in2004." If you would like a tape of her recentappearances on Wall Street Week, or for questionsor comments, call 212-935-6909 or email@example.com.