The worst bear market since the Great Depression and the Crash of 1929 is over, and stocks will recover in 2003, predicted Jeff Applegate in a speech on Nov. 6 at Wharton. Unfortunately for Applegate, however, that recovery didn’t come quickly enough. A week after his visit to campus, Applegate, chief investment strategist at Lehman Brothers, was laid off by the company as part of a 500-employee downsizing.
Ironically, Applegate has been bullish about the stock market during the recent downturn, and, at least during his speech, gave no hint of changing his opinion. He pointed out, for example, that after long periods of weak prices, the stock market typically rebounds strongly, as happened after the first three years of World War II and after the first four years of the Great Depression. And it should happen again, he said.
“The market hit its absolute peak in March 2000, and it hit bottom, we think, about a month ago. It’s been a worse time for equities than after the 1987 crash, worse than all periods but the Great Depression. But we looked at this history and saw that, once the market hit its bottom, you would have a sharp swing back.”
Granted, Applegate’s former firm has an interest in trying to restore investors’ confidence in stocks. After all, Lehman is one of the nation’s largest traders and underwriters of stocks, accounting last year for 7% of the trading volume on the New York Stock Exchange. Even so, Applegate’s remarks came as other market analysts and economists were also saying the economy was poised for recovery. Consumers have continued to spend, and housing starts – a leading economic indicator – have stayed strong. Worker productivity has continued to grow as well.
And despite the stock market’s recent woes, the economy is in far better shape today than it was in 1932, Applegate said. If it could bounce back then, it should bounce back today. After all, 70 years ago, one in four Americans was out of work. Prices were falling rapidly, and lawmakers in Washington were pursuing wrongheaded fiscal policy by trying to balance the federal budget. “We know now that that’s not what you’re supposed to do when the economy’s in recession. You cut taxes and increase spending.”
Compare that with today, when the Federal Reserve, the nation’s central bank, has been lauded for its handling of the economy. Federal lawmakers cut taxes as the recession was beginning. And global trade is thriving, with tariffs being lowered around the world.
Still, Applegate said several things could stymie, or at least dampen, the recovery that he predicted. The main one would be a war with Iraq. But even there, he managed to find reason for optimism. Historically, stocks fall in anticipation of wars, he said. But investors tend to overshoot, pushing prices down too far. Once a war begins, they see they have overreacted and begin to bid prices back up.
That’s what happened with the Gulf War in the early 1990s. When the Iraqi army invaded Kuwait, stock prices fell in the United States, Western Europe and Japan, with investors fearing the war’s effect on oil prices. “But then the war starts in January 1991, and equity returns come back. Most of the effect of the war had been discounted by the market before the war even started.”
A bigger drag on today’s economy than another Iraqi war might be the larger war on terrorism. “It’s open-ended and could lead to increases in deficit spending and a diversion of investment from productivity-enhancing uses. “But then the Cold War went on for 50 years, and business cycles came and went, and bull and bear markets came and went.”
Applegate dismissed concerns expressed by some analysts that record levels of household debt could hamper economic recovery. “You could have said that at the start of every business cycle of the last century.”
He attributed high debt levels to changes in the way people use credit and in growing home ownership, not to consumers spending beyond their means. Innovation in financial products such as credit cards has allowed people to substitute credit for cash in routine purchases such as gasoline and groceries, he pointed out. “Most households pay that off every 30 days, so I don’t think that’s dangerous.”
At the same time, the level of home ownership and thus mortgage indebtedness has risen. Until the mid-1990s, about 63% of households owned homes, he said. But in the late 1990s, the level jumped to 68%. “That shows up as a liability, but I think it’s absurd to go negative on people owning homes.”
Though Applegate’s talk came a day after the Republicans had taken control of the U.S. Congress, he downplayed the significance of the election for corporate America. “Functional control of the Senate is 60 votes” – the number required to end a filibuster – “so the notion that this will mean radical change, well, it ain’t going to happen. You might see some relief on the double taxation of distributed earnings. But at the end of the day, you’ve got 100 lawyers in the Senate, so you’re not going to see tort reform.”
Applegate did offer a caveat to his bullish predictions. Every once in awhile, he said, a “paradigm shift” occurs that undercuts the historic trends on which Lehman bases its analysis. “Paradigm shifts are infrequent but they do occur, and when they do, things can change dramatically.”
From 1870 until 1958, for example, the average dividend yield on stocks typically was lower than the average bond yield. “But in October 1958, the dividend yield fell below the bond yield and never went back.” In other words, any economic model built on the previously sensible assumption of higher dividend yields was rendered obsolete. “At the time, the leading lights on Wall Street said it would go back, but it never did.”
That’s an example of conventional wisdom obstructing clear thinking. And investors, being human, continue to make those sorts of mistakes. Consider “two truisms that aren’t true,” Applegate said. One is that low inflation equates with high stock values. The other is that during periods of deflation — falling prices — investors should hold bonds, not stocks.
Applegate’s analysis indicates that “inflation is a determinant of asset values, but it’s not the only determinant.” Both the mid-1950s and the late 1990s saw low inflation. But the earnings yield on stocks exceeded the yield on bonds by a wide margin in mid-1950s but not in the late 1990s.
Likewise, Applegate has found that bonds don’t always beat stocks during periods of deflation. When prices are dropping less than 5% a year, stocks win. Only when prices are falling more than 5% a year do bonds trump stocks. “And you need to separate deflation into good and bad. Bad deflation is caused by falling demand like Japan is having today. Good deflation is caused by positive supply shocks like China is having today and the United States had during the Industrial Revolution. In periods like that, productivity’s great. Growth in gross domestic product is good. Equity growth is good. But prices are declining.”
Having noted Japan’s economic problems, Applegate singled out the country’s policymakers for criticism. “They have shown an infinite capacity for disappointing markets in the last decade” by failing, for example, to resolve the country’s bank crisis. “Japan is marginalizing itself in world markets.”
Applegate joined Lehman in 1995 from Credit Suisse First Boston, where he was also chief investment strategist. Before that, he was president and chief executive officer at Shearson Lehman Institutional Asset Management. He has also worked for E.F. Hutton, Smith Barney and H.C. Wainwright and Co. He earned his bachelor’s degree at American University and also studied at Oxford University.
Lehman’s parent is publicly owned Lehman Brothers Holdings. For the third quarter, which ended August 31, the parent company reported earnings of $194 million, or 70 cents per diluted share, compared with $309 million, or $1.14 a share, for the comparable period a year earlier. In a press release, Lehman chairman and CEO Richard Fuld attributed the drop in earnings to “the extremely difficult market conditions that continue to confront our industry.”
Net revenues for the quarter were $1.35 billion, compared with $1.63 billion a year earlier. For 2001, Lehman reported net income of $1.3 billion, or $4.64 per diluted share, excluding a $127 million one-time charge related to the Sept. 11 terrorist attacks, compared with net income of $1.8 billion, or $6.38 a share, in 2000.
Investment banks such as Lehman are especially vulnerable to bear markets since their livelihood depends so heavily on the market. “The stock market looks like it’s priced for Armageddon, and we don’t think there’s going to be Armageddon,” Applegate concluded. “If we’re right about the bottom, there should be a nice bounce back next year.”