But maybe you’re a glutton for punishment. Or perhaps you’ve missed all the risky fun of the 1995-96 bull market, as many people have, and you’re wondering whether it’s too late to get in. Whatever, we’re all brimming with the usual questions. Will the Dow Jones industrial average soar like an eagle to 7000, or will it sink like a submarine to 4500? Is the play in big blue chips or little “small cap” stocks? There’s no shortage of “experts” who, having failed to predict today’s market, are eager to tell you what will happen tomorrow. But remember: no one knows which way the market will move. Don’t believe anyone who claims to know.
All that said, let’s talk a bit about Alan Greenspan, who, with the November elections safely past, finally decided to say a little louder what he’s long been thinking. To wit: the market has gotten out of hand. There he was last month, quietly trying to talk the market down by discreetly letting it be known (via the Nov. 25 issue of The Wall Street Journal) that the Fed was worried about stock prices’ becoming a sort of financial “bubble” that was destined to burst. No one listened; stocks kept rising. So on Thursday Greenspan dropped his bombshell into an otherwise boring speech at a black-tie dinner in Washington. “But how do we know,” he asked, “when irrational exuberance has unduly escalated asset values, which then become subject to unexpected and prolonged contractions, as they have in Japan, over the past decade?” Translated from snorifying Fedspeak, that means: “Stock prices are too high.”
It woke up his dinner listeners, all right–not to mention foreign stock markets. “It was startling,” said speech attendee Herbert Stein, former economic adviser to the late President Nixon, “a clear warning.” U.S. financial markets had closed hours before the speech, of course, but Tokyo was just opening. The shock waves hit there like a tsunami. The Nikkei 225, Japan’s version of the Dow, promptly posted its biggest one-day loss of the year, shedding about 3 percent of its total worth. Hong Kong opened an hour later. There, too, stocks nose-dived as the news sped west with the sun. In London, stocks lost 4 percent in early trading, recouping half later in the day. Bourses in Germany and France were also hammered, and then it was New York’s turn. The Dow dropped at the opening bell, losing some 145 points (about 2.3 percent) before beginning a long, slow climb to close down by only 55. It gave lots of people the willies, including me. And Greenspan helped to calm jangled nerves only slightly, when he appeared Friday afternoon to give a speech in Philadelphia . . . and declined to say anything about the market.
Pricking pimples: There’s method to Greenspan’s seeming madness. It’s clear that Greenspan wants to talk the market down without raising interest rates or doing anything to upset the economy, which may be weakening. “He wants to prick the pimple before it becomes a boil,” said Fed watcher David Jones, chief economist at Aubrey G. Lanston & Co. in New York. “He thinks the market is too high, and he’s worried that will limit his freedom to act if the economy weakens next year and he wants to lower interest rates.” In other words, to avoid a bigger crash later on, Greenspan would prefer a little “soft” one now.
He’s probably right, too. We have plenty of reasons to be cautious with our money these days. There’s euphoria in the air. Lots of people have bought the idea that stocks will always, always, always out- perform other investments. Smart people who should know better talk as if the business cycle has been repealed. Among investors, a pernicious myth has arisen that something called “indexing” is a foolproof way to play the market. Ahhh, would that these things were true.
Yes, stocks have historically produced better returns over the long haul than other investments: 10.8 percent a year, compounded since 1926, according to Ibbotson Associates, compared with 5.7 percent for corporate bonds and 3.7 percent for Treasury bills. But the past doesn’t necessarily foretell the future. Nor are our stomachs always strong enough to survive the lurching ups and downs of the long run. Remember the 1973-74 market crash, when prices fell more than 40 percent? If you bought at 1973 highs, it took you almost 10 years to recover. And those who gutted it out had to endure a period in which many “experts” opined that the stock market was dead.
Today we can’t imagine the market as being any less frisky than a newborn bull. Shares have been buoyed by tons of money flowing into mutual funds. Much of this cash–no one knows how much–comes from those 401(k) retirement funds that 20 million to 30 million of us now call nest eggs. According to Access Research, we have three times as many 401(k)ers as we had 10 years ago, and their accounts hold a staggering $800 billion or so. Only about half that money is in stocks–but 75 percent of all current contributions are going into them.
We’ll advise you about investing for your golden years in the following articles. But for now let’s explore why we should worry about stock prices’ being so high. The answer is easy: because reality always reasserts itself. If stock or real-estate prices get way above the value of underlying assets, they sooner or later come down to earth with a thud. Take Japan, which Greenspan invoked. It was supposed to be a New Age market, immune to a fall. Right. Japanese regulators pricked the “bubble economy” in 1989; Japanese stock prices are now more than 40 percent (in yen) below that year’s high, and Tokyo land prices are down about 75 percent. That’s the very thing Greenspan wants to avoid.
Now let’s get down to brass tacks. What bothers a lot of us skeptic types is precisely one of the things driving this market–a crazy idea that you can buy stocks without regard for what they cost. As practiced by people who are buying stocks as commodities, this approach, called “indexing,” lets you forget about all that boring stuff mossbacks like me call “fundamentals.” Who cares about profits and cash flow and dividends at a few carefully chosen companies when you can own a piece of everything? Who cares what it costs? Just buy a piece of everything; it will do fine. Even I’m indexing, through NEWSWEEK’s 401(k) plan.
Market mirrors: Let me explain a bit more how this works–and outline some of the dangers. In the stock market, indexing doesn’t mean making out three-by-five cards and filing them in order. Rather, it means putting your money into investments, such as mutual funds, that mirror a market index, or maybe even a whole market. The prime example: the Standard & Poor’s 500, the best broad-market measure.
Take the Vanguard Index Trust-500 Portfolio, the nation’s second largest public stock fund, with $30 billion in assets. Unlike the No. 1 fund, Fidelity Magellan, Vanguard 500 doesn’t pick specific stocks. It just buys all 500 stocks in the S&P index. Some $7 billion of new money has flowed in this year, according to Vanguard. You can see why. Through Nov. 30, say the number crunchers at Morningstar Inc., a fund-analysis company, the Vanguard 500 outperformed more than 80 percent of all stock funds. For the five years ended Nov. 30, it outperformed more than 70 percent of them. Funds like this one are doing so well this year that many managers are said to be loading up on big, rapidly rising stocks like IBM, Intel and Microsoft, just to catch up to the indexers. This has driven up those stocks even more.
The best thing about indexing instead of stock picking is simple: costs. The average stock fund spends about 2 percent of its assets a year on management fees, brokerage commissions and such. The Vanguard 500 fund, by contrast, spends only three tenths of 1 percent of assets on such things. That 1.7 percent annual advantage mounts up over time. What’s more, indexing is easier on your nerves than chasing the financial fad du jour–not to mention saving you all the hard work of trying to pick your own stocks. If you heeded all the advice dispensed through newspapers, magazines, TV, radio and the Internet, you’d go out of your mind.
So what’s my problem? That when everyone starts doing something, it doesn’t work as well as it used to. S&P guesstimates that $500 billion of the S&P 500’s $5.6 trillion worth of stocks is in index investments. That doesn’t necessarily mean the indexing tail is wagging the market dog. But having 9 percent of 500 big companies’ stock owned by folks who buy it without regard to price means, purely and simply, that shares have been bid higher they would have been otherwise.
OK, so what should you do with your money? Sorry, that’s up to you. As for me, I worry about Greenspan’s warning–and the market’s seeming shrug. Better the market should fall from its current level than from, say, 8000 next year. I’m also worried, silly as it may seem, about the proposal to let Uncle Sam put our Social Security money into stocks. This isn’t about ideology; it’s about governments buying high and selling low.
Maybe today I’ll sell everything, but I doubt it. I’m only 52, with endless years until I retire, and I’ve got a strong stomach. The day before Thanksgiving I plunked a big piece of the retirement money I recently received from a previous employer into stock funds. There it will stay, doubtless signaling a market peak.
June 1987: Reagan appoints Greenspan to serve as Federal Reserve chairman.
October 1987: Fortune magazine quotes Greenspan as being bullish. The article hits newsstands just in time for a 508-point crash in the Dow.
December 1991: Greenspan cuts the discount rate to help the economy and bail out the banking system. The stock market rises 137 points over three days.
February 1994: The Fed raises short-term rates for the first time in five years. The Dow loses 100 points; bonds tank.
February 1995: The Dow breaks 4000. Greenspan nixes further rate hikes. Promises “soft” economic landing.
December 1996: Greenspan warns against “irrational exuberance.” Dow loses 145 points before climbing back.
