BARRON'S: Up & Down Wall Street

Mr. Market Avers

By Randall W. Forsyth

As usual, the economists had it all wrong. Scores of them worried whether the

stock market's slide would cause the dreaded double-dip recession. With more

Americans than ever having staked their fortunes to Wall Street, mostly close to

the stock market's peak more than two years ago, how could they not be reeling

from the effects of watching thousands of dollars of wealth disappear from their

brokerage statements? By choice or necessity, consumers would rein in their

spending, knocking out the only sturdy peg under the economy.

Those fears were assuaged, for a time at least, by the humongous rally that

culminated in a 447-point surge in the Dow Jones Industrial Average last Monday.

With the Dow up 13% in the space of only four days, many a previously tremulous

voice was ready to declare the bear market had bottomed.

That, however, was before last week's parade of economic numbers that was as

remarkable in its uniformity as its negativity. In one of its regular rewrites

of economic history, the Commerce Department reported that the economy actually

did contract for three quarters, rather than just one, last year. Not only was

the recession more serious than government statisticians guessed, the recovery

is turning out to be decidedly more punk as well.

After shrinking in the first three quarters of 2001, gross domestic product

did rebound at a 5% annual rate in the first quarter of this year, mainly

because inventories were being liquidated more slowly. In the June quarter,

however, real GDP grew at only a 1.1% annual rate, about half the expected pace.

But that also owed to inventories, which were being rebuilt; without that boost,

real final demand shrank at a 0.1% annual rate in the latest quarter.

And the third quarter got off to a slow start. Friday brought news that the

job market also was soft, with businesses expanding their payrolls by only 6,000

workers in July. And though the jobless rate remained unchanged at 5.9%, people

were working shorter hours. Total hours worked -- a quick and dirty flash

measure of the economy -- fell a sharp 0.6% last month.

Even more parlous was the previous day's report from the Institute of Supply

Management, which showed a huge, 5.7-point drop in its index of manufacturing

activity, to 50.5 in July, just a half point above the level dividing

manufacturing expansion from contraction. Since 1960, drops of that magnitude,

according to the Goldman Sachs economics team, came only in the teeth of

recessions or when the economy was downshifting in a boom. The "shockingly weak"

report (Goldman's words) featured a sharp deceleration in previously robust new

orders.

So it turns out -- surprise, surprise! -- what was going on in the real

economy was driving the financial markets, not the other way around.

After the skein of weak data began to be unwound, the miraculous stock-market

rally began to be erased. Thursday's and Friday's slide almost exactly took back

Monday's big bounce. These 200-to-400-point swings certainly smell of big

hitters batting the market around. And could they be using exchange-traded funds

as a pinata? After all, you can sell an ETF short without waiting for an uptick,

as you must with a stock. With the popular QQQs, you get to short the 100

biggest Nasdaq stocks at once. And when there's a hint of a bounce, all those

shorts in the Spyders and Cubes rush to cover, sending the averages soaring, for

a day.

What is remarkable is that it isn't just stocks signaling economic weakness.

It's evident in the slide in the dollar, which bulls say is a plus for companies

with operations overseas. That ignores the turmoil in Latin America, most

recently Brazil, where the real plunged when our diplomatically challenged

Treasury secretary suggested that another aid package might only fund capital

flight to, of all places, Switzerland.

And closer to home, the economic woes are most evident in the bond market,

where short-term Treasury yields plunged to new lows. The two-year note, the

maturity that dances to the Fed's tune, got down to 2%, only a quarter-point

above Greenspan & Co.'s target for the overnight rate. The interest-rate markets

are beginning to price in the fed-funds rate of 1 1/2% later this year, while

Goldman Friday forecast a half-to-full-point cut in the fourth quarter.

Monetary easing may prove a temporary palliative, but there are risks of side

effects. Ignored amidst all the bad news was the sharp rise in one economic

indicator -- the Economic Cycle Research Institute's Future Inflation Gauge.

"Despite the mildness of the recovery, U.S. inflationary pressures are clearly

gathering steam," said ECRI. Slower growth, higher inflation; sounds like

stagflation. Where have you heard that mentioned recently?

The perpetrators of the "Dow 36,000" hoax were back out last week, opining

about their curious notion that stocks aren't risky, if you hang in there long

enough. Sort of like the old saw that an infinite number of monkeys at an

infinite number of typewriters eventually will produce a sonnet. (Although one

might mistake this column for an effort by such a cohort, rest assured I had a

shorter deadline.)

Judging by the mutual-fund flows as the market did its best impression of golf

ball bouncing down a flight of stairs, Jane and John Q aren't hanging around to

see if there really is a happy ending to that fairy tale. Last week, however,

after seeing a couple of multi-hundred-point daily gains, they did rush back to

plunk down $2.2 billion in the week ended Wednesday, relates Bob Adler,

proprietor of AMG Data, although almost all of that went to overseas funds.

That seems an aberration, given the emotions evidenced in the latest readings

on the confidence -- or lack thereof -- among consumers, which in no small part

seems to relate to the feeling they get when they open their fund or

brokerage-account statements. Seeing that their stocks have been split in two,

without any corresponding distribution of new shares, it is difficult to see

what will prevent them from resuming their rush for the exits.

That's even if -- a very big if -- the market actually has reached its nadir

and is about to begin a long-term recovery. But let's make that brave assumption

nonetheless. Even so doing, an examination of history isn't encouraging.

Salomon Smith Barney economist Steven Wieting looked at what would happen if

the market, which has thus far followed the pattern of 1929, would proceed to

recover from here in like fashion. He overlaid the current bear market with 1929

and its aftermath in the chart on the previous page. He notes that after that

Great Crash, it wasn't until 1954 that the market regained its '29 levels. So,

Wieting cheerfully notes, it'll be only another 23 years until the S&P 500 gets

back to its 2000 peak, if the market follows the same script.

To get there from here, he calculates, would take about a 5% annual total

return (including reinvested dividends that provide an assumed 2% yield), which

doesn't sound like much but, Wieting reckons, would likely beat bond returns.

That's not unreasonable given the benchmark 10-year Treasury yields about 4

1/4%. But Jim Paulsen, the deflation-minded chief strategist at Wells Capital

Management, points out there are long stretches where the stock-vs.- bond

contest has been a "push": 1870-1900 (a period of huge technological

innovation); 1910-45, and 1965-82. "Undoubtedly stocks will far outpace bonds in

the next 100 years . . . but we are not so sure that bonds will do that poorly

in the next 10 years," he writes.

Wieting supplied his Excel spreadsheet with his graphic, which allowed some

what-if noodling. Such as plugging in a higher assumed return going forward. How

about Warren Buffett's rather conservative forecast of 6%-7% (again assuming 2%

from dividends) long-term returns from equities? That gets the S&P back to its

peak price around 2015. And if we revert to the 9%-10% historical returns (also

including 2% from dividends), the S&P climbs back to its 2000 peak in 2010.

Now that's looking only at the price level of the S&P, without sustenance of

dividends and their reinvestment, which have made up a major part of equity

returns over those spans when the market wasn't shooting the moon. But the index

numbers are what get investors' attention. Otherwise, why are books titled "Dow

36,000"?

And when will the DJIA roughly quadruple in price to that lofty level under

these scenarios? At the 9.5% historical total return (including 2% dividend

returns), by 2022. (Wasn't that about when the federal debt was supposed to be

paid off?) At Buffett's assumed rate, it'll be in 2032. And at Wieting's

conservative rate, Dow 36,000 arrives in 2059.

Mark your calendars.

-- As in every bear market, some of the best laid plans for retirement have

gone awry. And the more ill-conceived schemes have totally blown up.

Among them: the Garden State Hedge Fund. That's not what it was called

officially; the actual monicker is the New Jersey pension bonds of 1997.

Rewind five years, when irrational exuberance was thick in the air. New Jersey

issued some $2.75 billion of bonds to cover the state employees' unfunded

pension liabilities. The administration of then-Gov. Christie Whitman came up

with the idea of the massive borrowing to avoid a tax hike to cover a yawning

budget deficit in an election year. (Whitman since has moved from Trenton to

Washington to run the Environmental Protection Agency, which given New Jersey's

air quality, seems equivalent to naming stock manipulator Joe Kennedy as the

first SEC chairman.) The notion of the bond plan was irresistible: Take the

proceeds, invest them in the stock market, where they were absolutely certain to

earn a higher return than the interest rate on the bonds. In so doing, the

state's taxpayers would save some $42 billion in pension costs over the life of

the bonds. Like they would say in AC (that's Atlantic City to those who don't

hail from the Garden State or watch "The Sopranos"), a lead-pipe cinch.

The arbitrage has worked in reverse, however. Instead of earning a return in

excess of the bonds' interest tab of 7.64%, the state's pension funds have lost

about 9% and 10%, respectively, in the past two years, resulting in a decline in

their investment portfolio to $72 billion from $94 billion. And that's before

this year's sickening plunge.

As a result, the New York Times reports, the state may have to pony up $1

billion in pension shortfalls. Moody's cited the need to start making annual

payments of "several hundred million dollars per year" as one reason for the

downgrade of the state's credit rating last March. In addition, the state also

has to begin servicing the pension debt, to the tune of $160 million in the

fiscal year that began last month, and escalating in subsequent years.

Not exactly how it was supposed to turn out. But when I criticized the scheme

in these pages five years ago as a massive margin loan, the state treasurer

lambasted me for my "misguided opinion." The plan, he said, represented "sound,

prudent fiscal management," no different from refinancing a home loan when

interest rates are low.

Ultimately, the treasurer proved to be as facile with words as with numbers.

He explained the borrowing plan to the local press at the time with a rhetorical

flourish worthy of the Bard of Montclair, Yogi Berra: "It sounds too good to be

true, but it is." Indeed, it was.

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