Why stocks will plunge

0 Comments | Insight on the News, April 22, 1996 | by Charles A. Cerami

Those who fear that stock averages are headed for a massive correction are being drowned out by market analysts who say big declines are a thing of the past. But stock declines are a necessary part of the system. And since most Americans are heavily invested in stocks -- because so much pension money goes into mutual funds -- one must recognize that the chance of a plunge is 100 percent.

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It's true that the long string of winning years will encourage shareholders to leave their money in mutual funds after the market inevitably drops, even after two or three reversals. But these investors expect the quick recoveries to which they have become accustomed. When the market drags on uncertainly, however, a few will decide to redeem their shares -- to cash in their chips. Some funds will have to sell stock to supply that cash, causing the market to sink a bit more. Sooner or later, at a month's end, financial pages will report the rare fact that there were more redemptions than new investments.

"What the hell is this?" some investors will exclaim. "Maybe I'd better take part of my money out." Other hardy souls will hang in longer. But they, too, will grow restless. Baby boomers have been told that the averages always climb. The growing number of pullouts will challenge even the coolest fund manager.

All this is deja vu. Yet today is different -- it's worse. The fact is, many investors are in the market to supplement inadequate pensions and iffy Social Security. Imagine the panic when people see their retirement money disappearing.

Clearly, investors can't win big forever. With good politics and sound management, most people can live well on salaries, pensions and reasonable investment income. But they all can't enrich themselves at rates of 20 or 30 percent each year. The stock market would be pumping more buying power into the economy than the federal government. And the resulting inflation would make dollars worthless, giving investors all fat equity statements that wouldn't buy anything. The market would collapse under its own success.

Why can't there be a healthy stock market that grows moderately along with a growing economy? Because stock investments are known as "risk capital." This market is fueled by investors and money managers who aim high. They'll stay in as long as the rocket is on the expected trajectory, then hope to bail out before the descent. But note: The descent must come. It's part of the trip. The higher the rise, the farther the fall -- not necessarily taking us back to a Dow Jones industrial average of 700 or 800, but quite possibly to 2,500.

The reassurance that the current price-to-earnings, or P/E, ratio, is a quite normal 18-to-1 could be exploded in a matter of months. Everything depends on the earnings figure -- how many billions that little "1" stands for -- which is poised to fall. A soft year in sales of automotive products and major appliances easily could bring corporate profits down 20 percent, which would bring the P/E ratio close to the 22-to-1 that precipitated the 1987 crash. At today's market level, that kind of tumble would take $100 billion out of the economy, chilling consumer spending and making stocks seem overpriced.

Only after that, individuals, corporate officials and mutual-fund managers, reviewing the soundness of various investments, could find excellent buys at new low levels. Regular flows from retirement plans could provide a stream of money for what amounts to "dollar-cost-averaging" -- which means that the new dollars acquire a lot more shares once they have been cheapened. But there's the rub: Stocks have to get cheaper.