More of the Same for Stocks in 2003

Last January, I described 2001 as a "wildly frustrating year for stock market investors," and I predicted more of the same in 2002. Most investors would have gladly settled for "frustrating" last year. Unfortunately, the year was an unmitigated disaster for most market participants.

Disastrous because everything was hit hard -- growth or value, small-cap or large-cap, momentum or no-mentum. Basically, if it wasn't a gold stock, it went down. Even many of the shorts missed opportunities, as explosive bear market rallies forced them into covering at inopportune price levels. According to preliminary reports, the average hedge fund, supposedly positioned to exploit such volatility, generated flat returns in 2002.

When the average professional investor writes his year-end review or attends his client meetings, the evaluation will include many reasons to justify large stock market losses. Undoubtedly, it will include the unforeseeable events that unleashed the bear, such as gross corporate malfeasance or the unprecedented decline in investor confidence.

The Bear Wins Again

Certainly the impact of fraud and mismanagement was quite significant during the bear market of 2002. But corporate malfeasance was hardly the only factor responsible for such a difficult year. In fact, with the Enron scandal, the impact of an investor backlash on the stock valuations was quite predictable.

The most significant factors contributing to this bear market were high valuations and disappointing corporate profitability. Remember that 2002 began after a massive fourth-quarter rally in 2001. Investors dismissed valuation concerns almost as readily as they had a few years earlier.

High price-to-earnings ratios were useless because rate cuts by Alan Greenspan would rescue the economy and result in a potent profit recovery. New bull markets always arose from periods of weak economics and depressed profits, the bulls contended, and 2002 would be no different.

But it was different. Historically, prior high price-to-earnings-ratio market bottoms were in fact low price-to-sales-ratio buying opportunities. In the 1930s, 1970s and 1980s, bear markets bottomed at around 40% of revenue for the major indices.

Not in 2002. Stocks were down, they just weren't cheap. The year began with price-to-sales ratios (160%) for the S&P 500 at levels indicative of past bull market peaks. At this price-to-sales ratio, the stock market discounted a monumental profit recovery. Such a recovery never occurred.