Fear Has Its Way in the Stock Market

In 1999, a couple of fellows wrote a book called Dow 36,000: The New Strategy for Profiting From the Coming Rise in the Stock Market. They wrote that given stocks' long-term outperformance, equities were one of the most risk-free investments one could make. Stocks were safer, even, than bonds.

Alas, stocks don't look so safe anymore. Well before the events of Sept. 11, shares' steep decline from their 2000 highs showed that investors were reassessing the stocks-are-safe thesis. Even so, price-to-earnings ratios remain above historical norms. And in the wake of last week's terrorist attacks, it's difficult to convince investors that they should embrace any kind of New Math.

Indeed, stocks have come to be perceived as far riskier than they were just over a week ago. Investors once thought they could handle the stress of having a big chunk of their finances in the stock market. But in an uncertain and frightening world, taking on risk like that doesn't make as much sense.

"People are realizing what risk is all about again," says Merrill Lynch chief quantitative analyst Rich Bernstein. "But I still don't think we've gotten to the point where the risk premium is at the correct level." Bernstein has long advocated a conservative approach to the market, encouraging clients to diversify investments across different asset classes and to keep their stock investments focused on defensive areas, like consumer staples. He's sticking by that now, though he counsels against going whole-hog into anything at the moment.

"There will be a lot of knee-jerk reactions and knee-jerk themes out of this," he says. "We should sit back, relax, let some consensus form and analyze whether that consensus is right."

If the consensus ends up holding that stocks are riskier than people thought, then the market may end up in the midst of a self-fulfilling prophecy. Consider: Though by no means is everybody in America heavily invested in the stock market, investors and noninvestors alike sleep in the same tent. The America where investors are more risk-averse is an America whose people in general are going to be more careful with their finances, scaling back expenses, cutting out purchases deemed frivolous. In such an environment, the recession that many economists now forecast deepens, profits decline and, as a result, stocks suffer.

But one can argue that investors' current perceptions of risk are excessive. The easiest way to figure out investors' assessment of stock market risk is to look at market volatility expectations in the options arena. They are high. The Chicago Board Options Exchange's volatility index for the S&P 100, the VIX, has closed over 40 only 18 times in the past five years. Two of those times were this week.

"Perceptions of volatility are almost always incorrect," says Bollinger Capital Management head John Bollinger. "People try to use big volatility as a forecast for big volatility and small volatility as a forecast for small volatility. When nothing is happening, they can't imagine anything dramatic happening. And when dramatic things are happening they can't imagine nothing happening."

With the future so uncertain, it's impossible to tell whether current prices are over- or understating risk in the stock market. Absent a crystal ball, there's no objective truth here. If there is swift and effective action against those responsible for the Trade Center bombings, if we can quickly enter a world where people personally feel safe, then stocks will be seen as safe as well.

If, on the other hand, there's no sense among Americans that the situation has been defused, perceptions of the stock market as a place of enormous risk will endure and deepen. And stocks will keep falling.

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