While the war in Iraq is far from over, the fog of uncertainty that obscured the view of what's ahead is lifting. The future is never crystal clear, but, as I pointed out last month, there's a big difference between the traditional risks inherent in stock investing and the condition that economist Frank Knight in the early 1920s called "uncertainty," "ambiguity" or "ignorance" -- that is, a confrontation with a situation both frightening and rare.
Earlier this month, we faced the worst Knightian uncertainty of the past dozen years. As John Maynard Keynes wrote in 1937: "About these matters, there is no scientific basis on which to form any calculable probability. We simply do not know!" Under such conditions, many investors -- like many corporate managers -- simply decide not to play, to wait until visibility improves.
Waiting, however, can be costly -- because periods of uncertainty frequently offer exceptional opportunities for investors. When the view ahead is clear, stock prices reflect that clarity, and bargains are hard to find. But in a fog (or sandstorm) of Knightian ambiguity, fearful investors are often willing to part with their shares at attractive prices. In mid-March, for example, Citigroup (C), the financial giant, was trading at a price-to-earnings ratio of just 11, and fast-growing retailer Target (TGT) at a P/E of 15, about half its average of the past five years. Each had risen 15 percent by the seventh day of the war.
My guess is that uncertainty hasn't entirely dissipated and that stock prices remain unnaturally depressed -- but this situation probably won't last much longer. Yes, stock prices will be affected by what is happening on the battlefield (where the ebb and flow are, in fact, fairly clear) and by developments in the economy, but the profound geopolitical uncertainty will lift, to the benefit of shareholders.
I heard a top government official describe the uncertainty of an Iraq war this way: "There is a 5 percent chance of something truly catastrophic happening." The figure itself was obviously just a wild guess, but the gist is correct. As the war proceeds, the uncertainty will dissipate.
In such an environment, what should investors do?
The answer will sound boring. It's to keep investing in stocks regularly and broadly. There are no guarantees that prices won't fall in the short term, but, in the long term, the historical trends are powerful and undeniable. In periods of uncertainty, do what you do in times of calm -- buy good companies and mutual funds with the intention of holding them for a long, long time.
But in times like these, it's difficult enough just to hang on to what you own. Why buy? Three reasons, from the specific to the general . . .
* Wars can be bullish. Let's be clear: War is a horror. It kills people and consumes money and resources. Any sane person would gladly sacrifice many thousands of points on the Dow for the safe and successful return of coalition troops from Iraq. But history shows that wars often boost markets -- probably because the conflicts themselves change a situation that has become threatening to the well-being, and even the survival, of citizens in the affected countries. In the case of some wars, that means just about everyone in the world.
Bob Prince and Jason Rotenberg of Bridgewater Associates in Wilton, Conn., recently looked at stock prices before and after five U.S. wars. They found that stocks tended to "trade sideways" in the 12 months leading up to the war. Then, they write, "we see that stocks rallied after the beginning of WWII, the Korean War and the Gulf War, didn't respond much to the Vietnam War . . . and fell and then rebounded after the start of WWI."
Vietnam appears to be the anomaly, mainly because its inception was so vague and its duration so great. But Iraq is different, too. The prewar period "has been much weaker than normal," mainly because of the "post-bubble" economic fallout, write Prince and Rotenberg. I would blame the weakness on the high Knightian uncertainty this time around -- mainly because of the effects of 9/11.
If that's correct, then stocks could rally even more over the next few years than they did after the other wars. And those rallies were impressive. From 1942 to 1946, the Standard & Poor's 500-stock index increased 148 percent. Stocks jumped 50 percent in the 18 months after the Korean War began and 31 percent during 1991, the year of the Gulf War.
Bear markets are for buying. In a study of every bear market since 1932 (except the current one), InvesTech Research found that within six months of hitting bottom, stocks rose, on average, 28 percent; within a year, they rose 46 percent. Resilience is a primary characteristic of U.S. markets. From 1929 to 1931, for example, stocks dropped 61 percent, but over the next three years they rose 94 percent. In 1973 and 1974, stocks dropped 37 percent, but over the next two years they rose 70 percent.
The catch, of course, is that it's never clear where the bottom is. Remember the aftermath of the terrorist attacks: It appeared that the strong recovery in late September 2001 signaled the end of the bear market that had started in March 2000. Instead, after a powerful recovery, the bear resumed -- and became one of the longest and deepest in history.
Whether the global bear market bottomed out earlier this month is impossible to say, but waiting for prices to rise before you invest tends to be a bad idea. No one blows a whistle to indicate the end of a bear and the beginning of a bull, and when stocks start rising, they tend to surge powerfully and unexpectedly. We got a taste of that phenomenon recently when the Dow Jones industrial average jumped from 7488 on March 10 to 8552 on March 24, a 14 percent increase in 10 trading days.
* Stocks go up. The other reason to own stocks for the long term -- no matter what the geopolitical setting happens to be -- is that history shows they go up. Between 1926 and 2002, large-cap stocks returned an annual average of 7.1 percent after inflation; long-term U.S. Treasury bonds of that period returned 2.3 percent after inflation.
According to T. Rowe Price Associates, stocks have beaten bonds in 78 percent of the five-year periods over the past three-quarters of a century -- and in 98 percent of the 20-year periods. And, while stocks have produced negative returns in roughly one-fourth of the calendar years since 1926, they have been losers in only one-tenth of the five-year periods during that time and one-twentieth of the 10-year periods.
In placid times, stocks are a good buy, but in turbulent times they are usually a better buy. Barton Biggs, the Morgan Stanley strategist who was extremely bearish during the booming late 1990s, has now turned bullish during the depressing early 2000s. In a recent letter, he reminded clients that "the somber mood could change very quickly" and that it is "plausible" that the market could rally as much as 40 percent to 50 percent from its March low.
That figure sounds about right. The Web site Economy.com uses a quick-and-dirty "stock market valuation calculator" to estimate the fair value of the benchmark Standard & Poor's 500-stock index. Assuming corporate profit growth of 9 percent over the next year and a yield on the 10-year Treasury bond of 4.75 percent, the calculator concludes that the S&P is significantly undervalued today. It should be about 1300 rather than the current 900. Why isn't it there now? The answer, almost certainly, is continuing uncertainty, which, in technical terms, raises the equity risk premium (the extra return that investors demand from stocks because they're perceived as riskier than bonds), which depresses prices.
Frankly, I have no idea how high the market will go in the short term, but it stands to reason that a period when uncertainty is lifting is a good time to buy.
But buy what? Biggs says he "would emphasize U.S. technology, U.S. and European diversified financials including insurance, pharma, capital goods, and materials."
"Germany, as the most cyclically sensitive market in Europe, should do well," he says. "I think emerging markets will come on very strong."
Investors should spread their money throughout the equity markets, but the emphasis, I believe, should be on growth. Why? In times of uncertainty, investors don't care about fundamentals. They are frightened of stocks in general, and they don't want to pay a premium for companies that have shown they can consistently boost profits. As the economy recovers, those same investors will be happy to pay up for companies with growing earnings. A smart move is to beat those investors to the punch.
Elliott Schlang of Great Lakes Review, a research service for institutions, recently pointed to eight companies that feature "dependable growth" and that "do things right consistently" but that, nevertheless, "thanks to indiscretionary price movements," have fallen from earlier highs.
One is Dentsply International (XRAY), the world's largest maker of dental products. Dentsply's earnings have risen in a Beautiful Line each year since 1993. Cash flow has increased at an average of 13 percent annually for the past five years, and Value Line projects roughly the same rate for the next five. The company has more than 1,000 patents, Schlang notes, and makes more than half its sales outside the United States. The stock, down 17 percent since October, trades at a modest P/E of 19.
Another is First Health Group (FHCC), which, writes Schlang, "returned an astounding 35 percent net on equity last year." First Health sells cost-management services to health care providers. Value Line expects the company to increase its cash flow at a rate of 15 percent annually for the next five years (its growth rate for the past 10 years was an incredible 30 percent), and it trades at a P/E of 20.
Others on Schlang's list include Zebra Technologies (ZBRA), bar-code printers; Cintas (CTAS), work uniforms; Alberto Culver (ACV), professional beauty products; and Education Management Corp. (EDMC), adult education.
Jim Collins, whose OTC Insight ranks second among 51 newsletters tracked by the Hulbert Financial Digest over the past 15 years, is enthusiastic about a wide range of growth stocks, including eResearch Technology (ERES), which provides research services for health care companies and has doubled in price since November; tiny John B. Sanfilippo & Son (JBSS), which processes nuts (highly desirable to Atkins dieters) and trades at a P/E of 11; and J2 Global Communications (JCOM), which offers advanced messaging services to businesses and increased its revenue 46 percent in the most recent quarter.
Finally, Value Line recently listed 15 "timely growth stocks" -- each with double-digit earnings growth in the past five years and a projection for at least that rate over the next five . Among the standouts: Danaher Corp. (DHR), diversified industrial products; Starbucks (SBUX); Amgen (AMGN), biotech drugs; Countrywide Financial (CFC), mortgage lending, at a P/E of just 9; and Omnicare (OCR), pharmaceutical services for long-term care institutions.
Buying growth stocks in this climate requires a certain amount of courage. But that's the whole point. When the sunshine breaks through and the fog of uncertainty vanishes, so will the bargains.
Of the stocks mentioned in this article, James K. Glassman owns Starbucks. His e-mail address is email@example.com.