Making the Case for Neutral Markets

The hope of a promising resolution to the war in Iraq jerked the market out of the doldrums, prompting the question of whether the bear market is over. There are compelling arguments from those who believe stocks are in for more pain and from those who believe the worst days are behind us.

The bearish case rests on the continuing weak economy, while the bulls feel that the bubble speculation has been purged, and that corporate America is running lean and is poised to see a ramp in profits in the near future. I'm sure both camps will have days of glee and doubt over the next few months. The best approach is probably one of flexibility. That is, don't make a committment that the market must or should necessarily do anything one way or the other over the next few years.

One man who has taken an objective long-term view is Jonathan Lin, a market analyst with Salomon Smith Barney. Lin thinks we're still in a structural bear market and will remain so for four to five years. "There will be some secular bull rallies, but basically the statistics are saying that investing right now is a waste of time," he says.

Neutrality Possible

Lin's opinion is drawn from his analysis of stock market performance over the last 100 years and is based on the premise that returns over time revert to the mean. When Lin first published his Reversion to the Mean study in September 2000, he projected that the S&P 500, on the basis of normalized annualized gains over 50 years, should bottom at 776 by the end of 2001. The timing was about a year off, but the price was right: The index hit 768 in October 2002.

"If you look at returns over the past 10 or 15 years, it encompasses the greatest structural bull market of this century and produces average returns of 15% per annum," he says. "I think a 50-year period, which at least includes one bear market and the current one, we get normalized returns of 9.3%."

The table below shows expected price levels for the S&P 500 index as a function of the normalized annualized gain for various time periods.

Reverting to the Mean Could Mean Years of Zero Gains
Time period	Annualized % Gain	Corresponding Price in 2001	Number of years of 0% Gain
90-year norm	5.63	632	15.87
50-year norm	9.33	777.24	7.83
10-year norm	15.15	1061	3.11
Source: Salomon Smith Barney