Many beginning investors today think that now is the time for cash. I couldn't disagree more.
Cash, of course, means moving investments to money market funds, bank certificates of deposit, passbook accounts, or under mattresses. Investors who do that run scared rather than make prudent investment decisions. Their risk aversion boosts the equity risk premium, or the excess return of stocks over bonds.
And many investment professionals are taking advantage of it, which I learned while listening to a conference call held by four of the chief investment gurus at the Oppenheimer Funds at the end of September. They believe that currently investors are adamant to avoid risk and that risk aversion creates opportunities for savvy investors.
Let's look first at the equity risk premium, which is often misunderstood. It measures the return from stocks minus the return from bonds. People are often confused by the equity risk premium because it is measured by looking forward -- at expected returns. So when we talk about the equity risk premium, what we mean is how much excess return we might expect from stocks over bonds in the future.
The average equity risk premium over time has been about 5%, based on the return of common stocks since 1926, which is about 8.4%, adjusted for inflation, minus the return from long-term government bonds of 3.3% after inflation. In other words, that's the reward paid to investors willing to take on the additional risk of investing in stocks.
A year ago, a study called "The Death of the Risk Premium," by Rob Arnott, head of First Quadrant, a money manager in Pasadena, Calif., and Ronald Ryan, president of Ryan Labs, a New York pension consultant, predicted "the evaporation of the forward-looking risk premium for stocks, measured relative to bonds." They argued that investors in the '90s had bid up stocks to levels where there was no remaining premium for the genuine extra risk of holding stocks.
The Return of the Equity Risk Premium
But now the folks at Oppenheimer say that the equity risk premium has increased as stock prices have plunged back to 1998 levels.
That makes sense when you think about it. The reason the equity risk premium exists is because lots of investors are running for cover, creating opportunity for investors willing to take risks. And when we say the equity risk premium has increased, what we mean is that stocks are likely to outperform bonds by a bigger margin going forward.
Why? As stock prices fall, the perceived downside risk diminishes, and the upside potential appears to increase. In other words, stocks start to look like "bargains." As prices rise, however, the premium investors are willing to pay for stocks over bonds diminishes as downside risk increases and potential upside decreases.
Like others on Wall Street, the folks at Oppenheimer think that the massacre of Sept. 11 created a "V" bottom for the recession. Len Darling, Oppenheimer's chief investment officer, expects an upturn by next year. Darling said that Oppenheimer examined all the postwar bear markets and found the average length to be 12 months with an average decline of 29%. As of the end of September, the current bear market has lasted 18 months with a decline of 37%, he said.
If you look back to the last recession in 1991, the major market indexes are below where you would expect them to be if stocks had moved up at an inflation-adjusted annual rate of 8% per year. That suggests that most of the market mania of the late '90s has been wrung out of stocks, and in fact, the markets as a whole are undervalued, at least in relation to historical norms.
That makes the Oppenheimer team positive about stocks, particularly technology, for a couple of reasons. Many companies, worried about the Y2K problem, replaced computers in 1999. The replacement cycle for computers is about three years, which means companies will need to replace those machines again next year. Add to this Intel's Pentium 4 and Microsoft's Windows XP, and Oppenheimer expects a significant increase in computer-related spending next year.
Going Against the Grain
As investors, we shouldn't listen to what some expert says and then run out and throw our money on the table. We are responsible for making our own decisions. On the other hand, there is something to be said for moving against the crowd. The crowd today is clearly opposed to taking risks. That means the rewards lie not in avoiding risk but in taking it on.
That's true in the bond market as well, according to Jerry Webman, Oppenheimer's fixed-income guru. The yield curve has grown steep, with a spread of 270 basis points between the two-year and 30-year Treasurys. (A yield curve plots the yield for government debt securities of different maturities.) Webman points out that investors can pick up additional income now by going longer in duration.
Typically, a steep yield curve signals inflation on the horizon. But that's not the case now, he says. The curve has been distorted for technical reasons like the flight to quality and the end of the government's buy-back program. "People are looking for the closest thing to money under the mattress," Webman said.
Opportunities also exist in the high-yield or junk bond market, where the spread between Treasurys and junk has increased to 850 to 900 basis points. Both of these opportunities offer "significant but not unreasonable risks," Webman said.
What should investors do who want to go against the grain? This isn't the time for beginners to shoulder the risk of individual stocks. Dollar-cost averaging into broad stock market indexes is the better way to go. A couple of weeks ago I bought the
Standard & Poor's
500 Stock Market Index, which trades on the American Stock Exchange. I chose a broad market index because I already own a good deal of the Nasdaq 100 Trust, an index of the 100 largest non-financial stocks on the over-the-counter market. That is a good choice for investors who want more tech exposure.
I am not suggesting that either of these two indexes will take off next week or next month. But this is a good time to build positions for the future.
At the time of publication, Mary Rowland owned the following equities mentioned in this column: Standard & Poor's 500 Stock Market Index and the Nasdaq 100 Trust.