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Here's a vote against a quick market rebound

By Jonathan Clements

The Wall Street Journal

Sensible investing is dull. The market never is.

War in Iraq? A three-year bear market? Bond yields at a four-decade low? Like any prudent investor, I try to shrug off the turmoil and dutifully shovel money into stock and bond mutual funds.

That doesn't, however, stop me from analyzing the market action. I wouldn't bet serious money on the resulting insights. Still, for what they are worth, here are my three contentions about today's stock market:

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Stocks have become less risky, and that's a mixed blessing.

Stocks aren't cheap, and may never be again.

Stocks could rally strongly, but I wish they wouldn't.

With war raging in Iraq and the Standard &; Poor's 500-stock index still 43 percent below its March 2000 high, it might seem odd to suggest that stocks are less risky. But let's face it, neither the U.S. economy nor world affairs are nearly as volatile as they were in earlier decades.

Think about it: Today's economic turmoil is nothing compared with the Depression of the 1930s or the stagflation of the 1970s. Similarly, the current Middle East conflict, terrible as it is, pales next to Vietnam, Korea and World War II.

Today's stability is reflected in stock prices. Even after a three-year bear market, stocks are still pricey.

If your biggest fear is another big stock-market drop, this is good news. Apparently, we aren't going back to a world where stocks trade at 10 or 12 times earnings and yield 3 percent or 4 percent in dividends.

But if your goal is to earn healthy double-digit gains, the news isn't nearly so good. Historically, stock investors have enjoyed dividend yields that have averaged 4 percent and benefited from rising P/E multiples, which have added over a percentage point a year to long-run stock returns.

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But with stocks now yielding less than 2 percent and priced at around 30 times reported earnings for 2002, you won't make much from dividends and you are unlikely to see a big rise in P/E multiples. The implication: In the decade ahead, stocks probably won't match their historical 10.2 percent return.

"The guy who is sitting today with his retirement calculator and plugging in 10 percent for stocks is making a huge mistake," contends Clifford Asness of New York AQR Capital Management.

Asness who loudly proclaimed that stocks were overvalued in late 1999 and early 2000, doesn't think stocks are going back to 15 times earnings.

Why not? It could be that stocks are now less risky, as I suggested above. Alternatively, it could be that stocks were underpriced historically and that the impressive gains since 1925 reflect a one-time bonus, as stocks became more rationally priced.

Even if we average 7 percent or 8 percent a year over the next decade, that doesn't mean we will get that return every year.

It isn't just that the economy seems in decent shape and that investors might celebrate a victory in Iraq by bidding up stock prices. There are three other reasons share prices could soar.

First, stocks look like a bargain compared with bonds.

Second, contrary to conventional wisdom, stocks usually aren't deeply undervalued at the end of a bear market. Andrew Engel, an analyst at Leuthold Group in Minneapolis, notes that three-quarters of the bear markets since World War II bottomed when stocks were close to average valuations.

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Third, bear markets often end with a rally, with share prices soaring 30 percent or more over the next 12 months.

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