The financial market forecast.

• Author: Neal, Robert S.

A noted economist once said, "The five most dangerous words for investors are: This time really is different". So before trying to gaze into the crystal ball let's look backward and put the recent market performance in historical perspective. The S&P 500 generated annual total real returns (after accounting for inflation) of slightly less than 15 percent over the last 15 years (1986-2001),with the average over the last five years being just over 20 percent per year. This was much higher than the five percent real return on the S&P during the fifteen years from 1971-1985. Productivity growth, the expansion in global trade and the technological revolution were clearly important factors for the recent performance. However, two other factors emerged in the latter half of the 1980s and the 1990s.

The first factor was the level of inflation and interest rates. In the early 1980s interest rates on long-term government bonds and inflation were both around 14 percent. By the mid-1980s inflation had dropped to about five percent but the government bond rates were still in double digits. The mid-1980s saw the start of a fairly steady decline in interest rates that has continued to this date. Since rates and prices move in opposite directions, the drop in rates caused an increase in asset prices--stocks as well, as bonds. To see this effect, think of a security that was paying out $100 per year. At a rate of 15 percent, this security would sell for $667. If the rates drop to 10 percent the security price increases to $1,000. If the rates further drop to 5 percent, the price increases to $2,000. This is without any increase in the payout from the security!

The second factor is a change that occurred in the risk premium--the extra return that investors demand to bear higher risks. In the early 1980s Baa corporate bonds (the lowest investment grade bonds) were commanding a risk premium of about 3.5 percent above government bonds. By the late 1990s this risk premium had declined to about 1.25 percent. While the risk premium on common stocks is hard to estimate, without question it followed a similar pattern. This drop in risk premium magnified the decline in overall interest rates, with a consequential increase in stock prices.

The net result is that these two factors enabled investor's returns in stocks to outpace the growth in profits. In looking to the potential returns for the next year and beyond, we have to recognize that these factors will not be...