Hope for asset-hoppers

US investors will sigh with relief if the Dow hits 10,000 points again. Stephen Foley reports
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The Independent Online

It was a party atmosphere that heady Monday. When the New York Stock Exchange bell rang to mark the day's end at 4pm on 29 March 1999, traders stood and applauded for a full minute. The beaming New York mayor, Rudy Giuliani, stood on the balcony of the trading floor and threw specially embroidered baseball caps into the throng. The exchange chairman, Dick Grasso, effused that he wanted to "send thank-yous to the 70 million Americans who participate in equities". That White Hot Monday was the day the Dow Jones Industrial Average passed 10,000 points for the first time in a history stretching back to 1896.

Don't expect anyone to be partying like it's 1999 when the Dow passes that landmark again, possibly in the next few days. Traders have dusted off those caps, emblazoned with "Dow 10,000", and there will be a few toots on the party whistles of old, but actually the mood is one of relief mixed with disappointment.

After the near-collapse of the financial system and global economy last year, the index has regained its poise. Indeed, investors have made 50 per cent since the nadir this March. But there is no getting away from the fact: people who put their money in the market on White Hot Monday have precisely nothing to show for it, in terms of capital appreciation.

The question for investors now is whether this lost decade undermines the traditional primacy of equities as the best place to park savings over the long term. A debate is beginning to emerge between those who believe that the equity markets remain the best place to buy in to economic growth, albeit with reforms needed, and those who promote a diverse portfolio that includes property and commodities in higher proportions than before. Still more favour a radical, "asset-hopping" strategy.

The future is still being mapped but the history is clear. We were already in the grip of an equity bubble in March 1999. That is not just hindsight. Alan Greenspan, then chairman of the US Federal Reserve, warned about "irrational exuberance" in 1996. The promise of the dot.com revolution took years to be realised in the real economy. Investors got ahead of themselves.

"Valuations were simply way too high in 1999 and most observers said that at the time," says Jeffrey Kleintop, the chief investment strategist at LPL Financial in Boston. "It was a peak that set us up for a very disappointing decade. Stocks were trading at 30 times annual earnings, and they needed to come back to what had been the average over the vast long term, namely about 15 times."

Now, the US stock market is back to trading at 16 times, having plunged to 10 at its worst.

"Actually, we have had two different bubbles," says Tobias Levkovich, the chief US equity strategist at Citigroup. "First the technology bubble, and then the credit bubble, generated a strong burst for equity markets but showed an inability to sustain themselves."

Mr Levkovich is unfazed by the volatility, however. Take a long-term historical perspective, he says. Dow 100 was hit in August 1922, and markets stayed within a range of 100 for nearly 20 years. Dow 1,000 was no different. After coming within 1 per cent of that level on 18 January 1966, it traded around that number for more than 16 years.

"We spent years in the past trading around these logarithmic landmarks, so the fact we have been up above and down below 10,000 over this past decade is only par for the course. Remember, 70 per cent of the time stocks are up a year after you buy them, but that means that 30 per cent of the time they are not."

That is not to say that there should not be a re-evaluation about the best approach to equities, however. The trouble, according to Mr Levkovich, is that investors began to misunderstand the historical data and failed to appreciate how the tax code was undermining the performance of stock market investment.

"Over the past 100 years or so, stocks have provided an annual return of 10 per cent, on average, but only half of that came from appreciation. The other 5 per cent came from dividends. It was only in the Eighties that the balance began to shift to appreciation, and in the Nineties that dividend income became meaningless as a component."

The reason? America's tax policy, particularly since the Clinton era, has changed. Dividends, treated as ordinary income, came to be taxed more highly than capital gains, which led companies to whittle away their dividends.

"That was when we got off the long-term trends, and it was deeply unsustainable," Mr Levkovich says. "There was excessive optimism about likely appreciation, which was not supported by history. I don't think investors are starting to demand dividends again yet – not after a 50 per cent rally since the bottom – but if you are an investor for the long-term then I think dividends will become more and more important."

The boom in exchange-traded funds has given retail investors and hedge funds alike many more options for diversifying from equities should they wish. It is easier than ever to buy into commodities such as gold or oil, or even to trade currencies.

LPL Financial's Mr Kleintop is on the "asset-hopping" end of the spectrum of advisers. He says: "The long-term 'buy and hold' strategy is a relic of the past and active investing, though uncomfortable for some, is increasingly important for the long-term investor. Even just having a diverse portfolio is not enough. Last year, real estate, stocks, bonds, even gold and oil – they all went down together, so an adaptive approach is necessary.

"Whereas in the Eighties and Nineties it was possible for advisers to put their clients in equities and watch them go higher, year after year, in the past decade, guys like me have been able to demonstrate some value. If we haven't, then shame on us." As an example of this new approach, LPL is currently advising clients to overweight equities, Mr Kleintop says. But he adds: "We are not going to overstay our welcome. They have been a good place to be for the last six months, but they are likely to hit headwinds in 2010 as the Federal Reserve starts to raise interest rates."

The Dow came within a few dozen points of 10,000 this week. It was headed in the wrong direction yesterday, at least in the first part of the day.

Much will hinge on whether investors are enthused by what they hear from the major American companies reporting third-quarter earnings over the next fortnight. In their results, and in their comments on the future, traders will learn if the nascent economic recovery is translating into better demand for goods and services, real revenue increases that could sustain the rebound and promote the reinstatement of all those lost jobs.

It is too early yet to say, but there is one thing that commentators agree on. Dow 10,000 is just a number. The index averages together the share prices of 30 of the most powerful companies in the US, that's all. The ebullience of White Hot Monday is not to be repeated.

"We have crossed 10,000 so many times now that the psychological effect has been whittled away," Mr Kleintop says. "Maybe the latest headlines might wake up a few smaller investors and make them worry about missing out, but I think it will have only a muted effect."