You don't need to consult a bookmaker for evidence that the odds of a solid return from stocks have been in flux since September 11. As soon as trading resumed on September 17, both the Dow and the Nasdaq promptly shed about 10 percent of their values, and in the following weeks they saw heightened volatility. Although the major indices were again approaching their pre-attack levels only a month later, it's quite clear that investors were still in the process of reëvaluating the risks in their equity portfolios. Risk is the possibility of loss. Rattled investors clearly perceived a greater chance of loss in the wake of September's events and slashed stock prices as a result. But what changed? Certainly, the "safety" of investing in the U.S. stock market opened to debate. At the same time, the debate is over as to whether or not we're headed for a global recession. (We are.) Which of the above changes will have the more profound--and lasting--effect on stocks remains very much an open question. In sorting through the changing nature of equity risk, it's best to start from the ground up--the ground in this case being the United States. U.S. Treasury securities, issued with the "full faith and credit" of the government, are considered the safest investment you can make--they're "risk-free" by investment standards. Equities carry a higher level of risk. That's because a very long list of factors--from competitive landscape and earnings volatility to market structure and liquidity--contribute to the variability of stock valuations, and hence heighten the volatility of investment returns. To be compensated for assuming those valuation risks, investors have required a higher return--the equity risk premium--from equities than they have from risk-free securities. According to professors Eugene Fama of the University of Chicago and Kenneth French of the Massachusetts Institute of Technology, the average real annual return on stocks from 1872 to 2000 was 8.8 percent, compared with a return on six-month Treasuries of 3.2 percent. That equates to an equity risk premium of 5.6 percent. What do those numbers mean? Essentially, investors have required more than double the return of Treasuries to shoulder the risk of equities. From another perspective, the equity investor is willing to pay much less for a stock that could one day be worth $1,000 than for a Treasury bond that will be redeemed for $1,000 by the U.S. government. Between September 11 and September 17, investors' risk premium clearly rose, reducing the current price they were willing to pay for stocks. Has there always been a "risk that the U.S. could be attacked" component built into stock prices? Perhaps, but it's an idea that many current investors had yet to consider, at least consciously. Not since World War I, when the New York Stock Exchange closed its doors for four and a half months, had the U.S. equity markets been closed for so long, inciting liquidity fears. Even as the bottom was falling out of the market during the past 18 months, at least the market was still there. It's not unreasonable to suggest that an attack-related disruption could happen again. Consequently, the higher equity risk premium may prove long lived. Officials from the NYSE and the Nasdaq have been discussing how one marketplace might serve the needs of the other were such a disruption to occur again. Observations of market risk may remain higher simply because such a contingency system is required. Neither is it unreasonable, however, to suggest that aspect of the attack-related effect could be quite short lived. A recent report by Morgan Stanley quantitative strategist Joseph Mezrich analyzed previous crises that required a response from Washington and concluded that a decisive answer produced nearly immediate drops in the risk premium. He goes on to suggest that, while the market will likely struggle as the situation in Afghanistan unfolds, clear, bold moves by U.S. President George W. Bush could cause the premium to drop the same way it has in the past. (Interestingly, two of Mr. Mezrich's three historical scenarios--the Gulf War and the oil crisis--involve Middle Eastern politics, suggesting that the modern equity risk equation might already have its own Middle Eastern element. The third scenario was World War II.) Of course, a more nuanced interpretation of the ongoing effects of the attack must go beyond the question of whether the physical infrastructure of the market remains at risk. In the short term, at least, the duration of attack-related risk aversion on investors' part could prove academic when compared to the real economic aftermath. Already tenuous before September 11, the economic picture took another hit, as the possibility of further corporate austerity and consumer pessimism became a reality. Technology analysts, for their part, responded by once again cutting earnings estimates aggressively. Analysts at Credit Suisse First Boston, for example, cut estimates for the communications companies they cover by a staggering 65 percent through October 1. They trimmed forecasts for hardware, semiconductor, and software and services companies by 38, 35, and 30 percent, respectively. CSFB's technology team also noted that 2002 numbers still seemed too high, calling the 36 percent bounce-back built into consensus estimates "overly optimistic." Even so, P/E-based valuations of technology stocks are still at a premium to the rest of the market. As of October 9, the 2002 price/earnings ratio for technology stocks remained at 30.5, compared with a level of 18.6 for the S&P 500. On top of that initial premium, an additional risk for investors now is that people might conclude that the "E" in the technology P/E is still inflated. In that case, the differential would be even larger than it appears, and investors may find it difficult to support such a valuation gap. Successful technology investing has always required strong screening and valuation skills. As the sector is hit from above and below, the stock-selection exercise has become--if you can believe it--even more difficult than it was already.
Copyright 2001 Red Herring Magazine