the earnings of corporate America to appreciate, from their cyclical lows. So, if you consider that earnings can recover very strongly over the next few years, you could expect the market to start rallying over the second half of this year [and] first half of next year as it becomes clear that the economy is recovering. Then that rally can be sustained by the fact that as profits go up, optimism will go up.
B.E.: How much of a factor will psychology play in any recovery in the near future?
GREEN: In the short term, the stock market is nothing but psychology. It reflects the balance between greed and fear [and] optimism and pessimism. Psychology determines what the discount rate of the market is [or] how much of a risk premium do investors have to earn relative to risk-free investments in order to have an incentive to go into stocks. The more optimistic folks are, the less of a premium they require and, therefore, the higher valuation they are willing to pay for the market.
PUGH: Psychology works a little differently from the corporate bond standpoint, with respect to the equity side. If you step back to last year, psychology was a tremendous driver of the market and there were a couple of really significant events. We had Enron followed by Worldcom, Qwest, and Global Crossing. All these major corporations with accounting fraud issues really challenged investors in terms of whether or not they could believe their financial statements. That was significant.
Another major event last year was the July sign-off period in which CFOs and CEOs had to sign on the dotted line, [verifying] their financial statements. That actually was a point when both the equity market and the corporate bond market rallied for a short period because people were saying, “Okay, I can start to believe a little bit more.”
Also, the leadership of major corporations got the message that they really needed to focus on paying down debt, and that is a trend that started to gain traction. All of those things came together, initially because of the problems, to create a horrible market. But then, as a result of the realization that a lot of it was being dealt with—not necessarily overnight, but over time—we started to see the psychology change. From October to November of last year everything crystallized to its worst point and then started to rebound, both in the equity market and in the bond markets.
ELEY: However long this current stock market rally goes, whatever economic growth we see over the next year or two, it is not likely to be nearly as strong as in past recoveries because you are not going to get increased capital spending or substantially increased employment.
I expect this year and next year [for] the market to perform in a milder manner than we saw in 2001 and 2002. However, I think that’s because of the political machinations that are going on—the lowering of interest rates and fiscal spending—but somewhere the federal