The stock market
bounced around during July, August and September without taking any major direction. The
S&P 500 Index lost 2 percent for the quarter and is now down 1 percent for the year.
The Dow Jones Industrial Average gained 1 percent but is off 6 percent for the year. Both
measures of the broader market did very well in August and by the end of the month had
nearly reached their all-time highs. However, September saw declines among larger company
stocks.
Stocks of smaller ("small-cap") companies,
measured by the Russell 2000 Index, were flat during the quarter but are still up 2
percent for the year. The technology-heavy NASDAQ lost 8 percent and is down 12 percent
since January. International stocks had a particularly difficult time, losing 8 percent
for the quarter and 13 percent for the year.
What Happened
In July, I noted that it was unlikely that the Federal
Reserve would increase interest rates again, and that there would be two main concerns for
the third quarter: the effect on corporate profitability of interest rate increases that
had already taken place, and the valuation of technology stocks. Indeed, those have been
the two factors holding down security valuations. Several large companies, including Dell,
Apple, Intel, Kodak and Xerox, have issued profit or revenue warnings. This has depressed
the stock prices of those companies and caused analysts to adjust their estimates for
other companies as well.
The valuation of technology stocks has been a particular
worry. Their rapid price rise over the past few years without a corresponding increase in
revenues has put emphasis on short-term results. When key revenue goals are not met, or
even when specific product releases are delayed, the value of these stocks drops.
However, it's not all bad. Although there has not been a
major market rally so far this year, there has not been a huge decline either. Indeed, the
huge continual daily swings we saw in the first half of the year have diminished, mainly
because the fears of another interest rate rise have abated. The economy is still going
strong, with good economic growth and low inflation. The goals of the Fed have been
reached. The declines we have seen in the market are very modest, particularly when you
consider that they came on the heels of the most impressive five-year run in its history.
Looking Ahead
The two factors at play last quarter, profitability growth
and technology values, should continue to affect stocks over the next three months. It
would not surprise me to see more disappointing earnings results, and for the market to
finish the year lower than it started. This is certainly not the time to be expecting
short-term profits in stocks — although I would say that in almost any era.
However, with the exception of technology stocks, I believe
that any overall declines will be modest. There is no sign of a recession, and it is still
unlikely that the Fed will need to raise interest rates. The key thing to realize is that
analysts are concerned not about negative profits, but about whether the growth in profits
will be sufficient to maintain the high valuations caused by the long-term market rally of
the late 1990s.
What to Do
Certainly my words are not full of optimism that the market
will return to those get-rich-quick days. But actions speak louder than words. I have
every penny of my long-term investment in equities. Why? Because I am not investing for
the next three months, or even the next three years. So, although there is no reason to
expect a huge market rise, I know that over long periods of time stocks are a great
investment and are likely to provide better returns than bonds.
Moreover, some of the great market run-ups have come when
no one expected them. For example, in early 1994 the market declined, and many analysts
feared a continued decline (mainly because of the potential for increasing inflation).
Many investors pulled out of the stock market and missed the beginning of the impressive
run-up we have experienced. As I see it, if you are investing for the long term, you run a
greater risk by exiting the market than you do by staying in.
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