The wreckage has been removed from the World Trade Center site. Scattered from Afghanistan, al-Qaeda has not mounted another attack on U.S. soil. The recession appears to have ended after three quarters of negative growth.


Yet a year after the attacks that sobered the nation and rattled Wall Street’s foundations, stocks remain mired in the worst bear market in a generation and the economy can’t seem to get out of first gear.


Now, however, investors seem less concerned with threats from abroad than with untrustworthy corporate officials and the lack of capital spending at home. Wharton finance professors interviewed shortly before the one-year anniversary of September 11 agreed that the U.S. economy likely faces a slow and uninspired recovery that will be a drag on corporate profits and stock prices for months to come.


“We’re kind of like a healthy person who got hit by a car. Basically we’re healing but it’s been slow,” says professor Andrew Metrick. “We face a lot more uncertainty than before. We could still get an infection.” The good news, Metrick adds, is that the year has passed without another terrorist attack. “Corporate scandals, while they don’t happen every year, do happen every generation. Troubling as they are, they are less troubling than terrorism. Compared to last September, I believe people would say they are less worried.”


Still, Metrick points out, “The uncertainty surrounding terrorism and a possible war with Iraq is not helping. If that were to get removed tomorrow, that by itself would probably end the bear market.”


Anatomy of a Down Market


Since March 2000 when the stock market hit its peak, the S&P 500 index has fallen more than 40%. Some $7 trillion in wealth has evaporated from investors’ portfolios. The magnitude of the drop, and the preceding boom in growth stocks, is similar to the bear market of 1973-75, notes professor Richard C. Marston, director of the Weiss Center for International Financial Research.


Professor Jeremy Siegel sees three distinct segments of the bear market. “First, from early 2000 onward was the unwinding of the tremendous bubble in technology and Internet stocks in the NASDAQ. During that phase, it’s of interest that the Dow Jones average and the non-tech sector of the market held itself extremely well; they didn’t go down much at all.


“The second stage was the September attacks which shut the markets down fast and furious. But it was followed by a quick victory in Afghanistan and no further attacks. The market celebrated by rising in March. The third leg had to do with questions about earnings viability and credibility. That has been the major source of the declines from March through now.”


The stock market will rebound when the economy and corporate profits do, the Wharton professors agree. And on that, there is good news, says Marston, because the underlying economy is far stronger than it was in the 1970s. “Let’s keep things in perspective. The 1970s were a decade of disastrous government policy and high inflation. Our economy this decade is so much stronger. Look at the key factors – inflation, growth, productivity growth, and unemployment. No sensible observer believes we are back in the 1970s. If the economy continues recovering, this will lead to corporate profit growth. Employment growth will soon follow.”


Numbers on those fronts have been discouraging of late. In July, the Commerce Department revised its growth figures, saying GDP actually fell in the first and second quarters of 2001, which were previously believed to have had positive, albeit minimal, growth. GDP also fell in the third quarter last year.


More troubling are economists’ revisions to the numbers for the first and second quarters of 2002. Commerce reduced its Q1 growth projection to an annualized rate of 5%, down from 6.1%. J.P. Morgan estimates the second quarter slowed to only 1.1%, down from an anticipated 2%.


The recession, the Bush tax cuts and the increase in government spending to fund the war in Afghanistan and the new homeland security agency have pushed the government back into the red after a brief period of surplus. But Metrick said the level of debt is not large enough to be a drag on the economy. “Frankly this is nothing like the Reagan-era deficits. The debt does not trouble me. We’re a rich country with a credit card balance that’s well within our ability to pay off.”


Siegel also considers the debt manageable but is concerned about the reduced revenue estimates in the most recent report from the Congressional Budget Office. “The shortfall in revenue has not been fully explained,” he says. “Whether it’s hiding some undetermined weakness, whether there’s underreporting or something that was faulty in past estimates, we don’t know.”


September Selloff


On Sept. 2, the markets had their worse percentage drop since Sept. 11, a selloff attributed by many to the release of disappointing manufacturing numbers. The Institute for Supply Management reported that new orders, a key indicator, had fallen for the first time since last November.


The markets rebounded later in the week after the Labor Department reported that unemployment dropped to 5.7% in August, a five-month low. The jobless rate had risen to 5.9% in June and July, the highest level in eight years. Some analysts expressed skepticism about the August numbers, noting that weekly unemployment claims had risen for three straight weeks and that employment in the manufacturing sector declined in August.


Siegel thinks the retreat was too large to attribute solely to the new data and says end-of-month options expirations and major declines in European and Japanese markets also were a factor.


But the lackluster employment growth is taking its toll. The Conference Board’s Consumer Confidence Index dropped for the second straight month in August and now stands at the lowest level since last November. The number of pessimists hasn’t increased, but the number of optimists has dropped, the Conference Board reported. Consumers rating business conditions as “good” fell from 20.2% in July to 16.6% in August while those rating conditions as “bad” remained unchanged at 22%. Consumers reporting jobs were plentiful declined from 18.8% to 17.2%, while those claiming jobs are hard to get remained unchanged at nearly 24%.


The slow job growth is reminiscent of the sluggish post-Gulf War recovery that hurt the senior George Bush’s 1992 reelection bid. “This is very early in the process – the equivalent of mid-1991,” Marston says. “The current President Bush has to face congressional elections with the economy very, very weak. Unemployment isn’t increasing but are a lot of jobs being created? The answer is no.”


Marston worries about the effect of Japan’s seemingly endless recession and the stalling of the European recovery. “We are the only industrialized nation with any kind of momentum at all,” he notes, adding that the “one good sign is consumers continue to spend. The auto figures for August were astounding. In terms of the short run I don’t see anything setting back the consumer short of a terrorist attack.”


Other positives are a rebound in productivity growth in the first quarter and the fall in the dollar, which will help exports. The Euro, worth $ 0.86 in February, now is worth nearly $1.


In the previous four recessions, Marston notes, the S&P 500 bottomed out several months before the recession ended and stocks rallied sharply afterward. But following the post September 11 plunge, stocks fell even lower in July. After the tech bust, the terrorist attacks, the accounting scandals and the fall in corporate profits – down 30% in 2001 for the S& P 500 – “investors want to see the profits, not just the profit forecasts,” he says.


The Wharton professors were generally pleased with what Washington has done in response to the corporate accounting scandals. “I think overall the government has handled this pretty well but they don’t have a whole lot of power to fix these kinds of problems,” Metrick points out. “These problems are deep and structural. The things they did I think are marginally helpful and not harmful.”


One change Siegel and Metrick would like from Washington is the elimination of the double taxation on dividends. “That would end the bear market because it would improve corporate profits,” Metrick says, but adds quickly that there is no chance of its enactment in this election year.

Risk-Averse Investors


In the meantime, it will take some time for investors to regain trust in the veracity of earnings reports after the damaging revelations by Enron, WorldCom and others. “I was quite relieved to see the deadline for CEO certifications (of financial filings) pass without any major new revelations. I think that was good news and I was a little surprised that the market has not reacted to that good news,” Metrick says. “We will have this overhang for a while until we see what profits really have been for the last five years.”


Siegel believes the lows the market touched in July will prove to be the bottom of this bear market. But he agrees it will take time for investors to regain faith. “I don’t see a massive bull market beginning. There will be a lot of backing and filling and sideways movement and volatility. We’re really going to have to see the extent to which earnings recover now that we are ratcheting down our expectation of growth. There needs to be rebuilding of confidence in those earnings. The damage a bear market does to psychology is not erased overnight.


“We see a lot of risk aversion in the market right now,” he adds.  “Many people are hedging – with options on the market, people buying Treasuries – which means there’s a lot of fear out there.”


It would help, Siegel says, if the Financial Accounting Standards Board and its international counterpart established a uniform definition for earnings, similar to the “core earnings” model proposed last May by Standard & Poors. Standard & Poor’s definition includes employee stock options grant expenses, restructuring charges from on-going operations, write-downs of depreciable or amortizable operating assets, pensions costs and purchased research and development. Excluded are impairment of goodwill charges, gains or losses from asset sales, pension gains, unrealized gains or losses from hedging activities, merger and acquisition related fees and litigation settlements.


Not everyone believes the worst of the stock market shake out is over. Professor Franklin Allen, co-director of Wharton’s Financial Institutions Center, suggests that even at current prices, price-earnings ratios are at historic highs. “I doubt if profits will grow that much to justify these kinds of stock prices,” he says.


The economy and stock markets, he adds, are about where he would have expected them to be at this point even without the terrorist attacks. Allen also is concerned about real estate prices, which have remained high. “I think it’s unlikely, with the stock market down by nearly half, that real estate can stay at the same level,” he says.


So where to invest now?


Siegel places a premium on “value” stocks with conservative accounting and consistent dividends. Some junk bonds now have attractive prices, he adds. “For two and a half years I haven’t liked tech stocks. Even though they’ve come down I’m still not in love with them. The drug companies have their own problems; eventually they will be a good long-term hold but short-term there is a lot of potential problems with control of drug prices, questions about drugs in the pipeline and liability problems.”


Marston’s current asset allocation model for what he calls a “moderate investor” – a person in his or her 50s working toward retirement – consists of 25% weightings for large cap value stocks, large cap growth stocks and mix of bonds and cash. The balance is made up of foreign stocks (15%) and small/mid-cap stocks (10%.) He predicts the dollar will continue to decline over the next five years, an argument, he says, for investing in foreign equities.


Small cap stocks, he notes, significantly outperformed large cap stocks in the recoveries following three of the last four recessions. In the 1981-82 recession, small cap stocks rose about 25% more than large caps in the 12 months after the market touched bottom. Coming out of the 1990 Gulf War recession, small cap stocks rose about 20% more than large cap stocks. But small caps, he adds, may have already gotten their bounce out of this recovery.


Marston cautions against over-weighting a portfolio with bonds, which get punished during recoveries. “In this low interest rate environment, retirements cannot be based on bond returns,” although high yield bonds may make sense for patient, sophisticated investors and foreign bonds can help with diversification.