It Takes Some Hindsight to See a Mushroom Cloud on the Horizon

A few nuclear bombs can really ruin your day, or so that 1970s-era line used to go.Let’s hope no one worried for even a minute last week that India’s sudden appetite for destruction might have a dampening effect on U.S. financial markets.

U.S. Treasury bond yields just gyrated in their usual (of late) thin-as-a-toothpick range, and the Dow Jones industrial average went on to a new high by Wednesday, though it gave some modest ground by Friday.

In eras past, news of a significantly higher ante in the nuclear card game might have at least provoked a small emotional response on Wall Street. India with the bomb, however, admittedly is not the item that average Americans today would put first if forced to draw up a list of meaningful threats to their 401(k) accounts.

(Also, wouldn’t India nuking Pakistan be akin to the United States nuking Canada? Wouldn’t there be a slight problem with radioactive fallout coming over the border? Oh, never mind.)

Neither, it seems, would East Asia’s deepening woes make the list. That region’s economic collapse over the last year was supposed to wreak all sorts of havoc with the U.S. economy. Sure, every American company with an earnings problem--or should we say, “earnings challenge”--in recent quarters has cited Asia, but the numbers that really count show the stock market near a record high, U.S. unemployment at a 28-year low and Los Angeles County home prices up 10% in April from a year ago.

Suharto who?

It is increasingly remarked that Americans have become entranced by the narcotic effect of a robust economy and soaring stock market since 1995, and that we are forgetting there’s a large and often dangerous world out there to which we are connected as never before.

At a minimum, the near-anarchy in Indonesia--the world’s fourth-most populous nation--and even more populous India’s insistence on

becoming a nuclear power are reminders of what can go wrong, in a decade in which so much has gone right, at least from the standpoint of an American capitalist.

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But when worried Wall Streeters shake their heads at U.S. stocks’ heights, they may miss the point. Given all of the trends favoring financial assets in the 1990s, the stock market almost certainly deserves to be where it is, even with the average blue-chip stock priced at about 28 times current annual earnings (versus just 15 times as recently as 1995).

The only question is whether those trends can be sustained. If they can’t be, then it would be logical for investors to reassess the value of stocks--which, after all, are simply claims on some assumed level of future corporate success.

Consider: It wasn’t so long ago that optimism about the U.S. economy and stock market was partly rooted in an assumption of rising prosperity in the developing world, as countries such as Indonesia grew a large and stable middle class of consumers who would buy more from us. Everybody wins!

But if that prosperity now is in question, as it certainly is in East Asia, it would seem reasonable to question whether U.S. stocks are worth ever higher prices. If Indonesia’s middle class has been set back five or 10 years, what replaces that formerly bullish element in U.S. stocks’ outlook?

Perhaps the American economy can stay on its current streak without outside assistance--as long as we all keep buying new homes and new cars in perpetuity. Perhaps a healthier, united Europe is the ticket. Or maybe China is still the great hope.

Just last week, Chinese President Jiang Zemin again lectured his countrymen on the need for job cuts now to raise productivity and ensure a richer future for China. “We must first solve the overstaffing problem that is haunting many state enterprises, and help them raise efficiency and competitiveness through laying off their redundant employees,” Jiang said, sounding more like a Fortune 500 chief executive than a card-carrying Communist.

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As long as there is still plenty of that pro-capitalist talk to go around in this world, it’s tough to blame American investors for believing that the long-term “fundamentals” support shoveling still more money into equities.

But let’s be honest: Many investors, perhaps far too many, aren’t thinking much about “fundamentals” at all today. Stocks (and certainly stock mutual funds) are being bought largely because the market has continued to rise dramatically, albeit with a few hiccups, since 1990.

Why would you not play a game that has been this much fun, and so rewarding? Why would you buy a bond yielding a 6% annual return when stocks might give you that return in one month?

It says something about the resiliency of the 1990s bull market that shares of a company like Hewlett-Packard, which has repeatedly fallen short of analysts’ earnings estimates over the last two years, still are up 40% in price since January 1997.

That isn’t as peculiar as it might seem at first glance. Even if HP isn’t hitting the numbers Wall Street wants to see, it still earned $685 million in its quarter ended April 30. We’re not talking about some Indonesian near-bankrupt here. Fundamentally, HP is a great American company with a bright future.

But when a stock like Entremed Inc. soars from $12 to $85 in one day because the tiny biotech company might have an effective cancer treatment--”might” being the operative word--is that a run-up based on a solid assessment of the fundamentals, or is it simply a mania?

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All investing, of course, is gambling on some level. But every generation of investors usually learns the hard way about the danger of getting so caught up in stock hype and euphoria about the future that basic rules about investing and markets are disregarded or forgotten.

Who knows what today’s red-hot Internet-related stocks are truly worth?

What we do know from history is that the eventual outcome usually isn’t pleasant when investors pay the prices that stock manias demand.

Byron Wien, veteran strategist at Morgan Stanley Dean Witter, noted in a recent essay that “the extreme volatility of the Internet stocks has some eerie parallels.”

“The mobile home stocks blew off in the early 1970s, oil service stocks in 1980, small-capitalization technology stocks in mid-1983, the whole market in August 1987 and biotechnology stocks in 1991. Buying a sector with little foreseeable earnings is a sign of overconfidence and a lack of careful analysis. Sector blowoffs are reasons to suspect trouble ahead.”

Wien, while listing in his essay the 10 most commonly discussed arguments as to why the bull market could go on indefinitely (low inflation, low interest rates, aging baby boomers’ saving more, etc., etc.), then follows those with 10 arguments as to why this bull run is looking dangerously overwrought (crazy merger activity, money supply soaring, stocks overvalued by every measure, etc.).

But the title of his essay really says it all: “Only the Old Guys Sell This Market”--investors old enough to remember what has gone before, old enough to remember that stocks don’t rise 30% a year forever, and old enough not to believe too fervently one’s own “magic” as a stock picker.

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Then again, maybe that is precisely who should be selling at this point--people too old to wait through a severe market downturn, if one ever arrives. Younger investors, although they’re likely to have more unqualified optimism about stocks today, also have the greatest ability to withstand a market plunge, sit through lower or even negative returns for a time, and wait for the fundamentals to make the market go again.

The argument that “If I sell, I’ll never get back in at the right time” is still a legitimate reason for long-term investors to stick with a diversified portfolio of stocks today.

The problem is that the true test of most investors’ ability to hang for the “long term” has yet to arrive. But it will.

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Tom Petruno can be reached by e-mail at tom.petruno@latimes.com.