We don’t usually lift yarns from other journals but this was the best market wrap we’ve ever read. We’re sorry for breaching the Wall Street Journal’s copyright but as compensation strongly recommend you subscribe to their site at www.wsj.com. We pay for their content and reckon it’s great value. This article sums up their great journalism.
Last year’s massacre of technology and Internet stocks marked the end of what many consider the U.S.’s biggest financial mania of the last 100 years. Yet it was a massacre that left much of the market relatively unscathed.
The Nasdaq Composite Index plunged 39.3% to 2470.52, the worst year since it was created in 1971, giving back almost all of 1999’s record 86% rocket ride. Its peak-to-trough 54% plunge represented a loss of $3.3 trillion in paper wealth, equivalent (in dollars if not in effect) to one-third of the houses in America sliding into the ocean.
But the Dow Jones Industrial Average fell only 6.2% to 10786.85 for the year. Though that broke a nine-year winning streak and represented its worst calendar year since 1981, the Dow’s peak-to-trough decline of just 16% was less than that of 1990, failing to meet the 20% bear market rule of thumb. The Standard & Poor’s 500-stock index lost 10.1% to 1320.28 last year, its worst since 1977. But excluding its technology components, according to ABN Amro strategist John Mullin, the index was down just 4%. Indeed, the Dow and the S&P 500 have given up less than a sixth of what they made when they tripled between 1995 and 1999.
“We’ve proven we can liquidate the excess and still not destroy the entire market,” marvels Jim Paulsen, chief investment officer of Wells Capital Management.
By contrast, the 1973-74 bear market clawed everything. The Nasdaq’s 60% slide then was the only time it has fallen further than last year. The Dow lost 45% and the S&P 500 48%, ending 1974 at their lowest levels since 1963.
The new year begins with investors wondering if Nasdaq’s bloodletting is the vanguard of a broad-based bear market. The answer depends mostly on whether the economy’s downshift in recent months is a pause in the longest expansion in a century or the first stage of a recession.
So far, much of Wall Street opts for the former view. Just as the Federal Reserve’s raising interest rates through last May eventually sank stocks and braked the speeding economy, economists expect it to lower rates soon and propel stocks and the economy forward again.
UBS Warburg strategist Edward Kerschner thinks we are at one of the five most-attractive opportunities to own stocks in 20 years, and he predicts the S&P 500 will gain 30% this year. Indeed, strategists as a group are the most bullish they have been in the 16 years Merrill Lynch has surveyed them. Merrill’s head of quantitative research, Richard Bernstein, finds this enthusiasm both ironic, given that cash and bonds both trounced stocks last year, and sobering, since markets usually bottom at the point of maximum pessimism, not optimism.
Get Crikey FREE to your inbox every weekday morning with the Crikey Worm.
Indeed, there are some gloomier forecasters who think last year set the stage not for a big rally but for several years of miserable stock performance. That is because the eight-year boom in technology investment that boosted productivity, kept inflation low and drove up stocks — especially technology stocks — also created enormous production capacity and has drawn in new competitors that could weigh heavily on profits for years to come.
Most of last year, it looked less like a bear market and more like a bubble deflating. From a low of 1419.12 in October 1998 after the debt markets crisis to its closing high of 5048.62 last March 10, Nasdaq climbed 256%. Based on the magnitude of the rise, the disconnect between valuation and economic reality, the number of ordinary investors drawn in and the sheer money involved, many market historians rank the technology/Internet bubble ahead of earlier U.S. manias such as radio and investment trusts in the 1920s, conglomerate stocks in the late 1960s and early 1970s and oil stocks and gold in the late 1970s and early 1980s.
Yahoo! rose from below $30 in fall 1998 to $250 last January when it was valued at $133 billion — more than Ford Motor and General Motors combined. At year end it was back to $30.06. And Yahoo is a profitable company. Web-page technology provider Akamai Technologies lost $56 million on sales of $4 million in 1999, went public in October that year, and was valued at $32 billion by January — more than Texaco. It since has fallen 94%.
“The first half of the year was the blowing off of speculative excess in the Net sector,” says Henry Blodget, Merrill Lynch’s Internet analyst, adding, “From 1995 to 1998, most investors actually underestimated the power of the Internet. In 1999, people began to overestimate it. But what was interesting in mid-2000, was the excesses moved into other sectors: business-to-business, then infrastructure, then jumped into optics.”
But Mr. Blodget also points out that as Internet valuations deflated, many solid, profitable New Economy companies proved highly exposed to the Internet bubble. “The average Net start-up raised about $100 million,” he says. “Of that, $5 million went to Scient or another professional services firm, $10 million to Yahoo or America Online, $5 million to Vignette or other software providers, a couple million to Exodus or another [Web] hoster, a couple million to Sun [Microsystems], a couple million to Dell.”
As the stock market turned off the spigot to money-losing Internet companies and the junk-bond market did the same to capital-hungry telecommunications companies, the likes of Yahoo and Lucent Technologies began to feel the pinch. Investors began questioning not just the price being paid for technology companies’ earnings [the P/E ratio], but the earnings themselves. Mr. Blodget had thought Yahoo would ring up $1.8 billion to $2 billion in sales this year, “Now I’ll be happy if they could do $1.5 billion,” he says. In August, Wall Street expected Lucent to earn more than $4 billion in its current fiscal year, which ends in September. Now it expects Lucent to lose more than $700 million.
But outside technology, most stocks were unscathed, and some even boomed. Old Economy stalwarts like Minnesota Mining and Manufacturing and Exxon Mobil were up 23% and 8%. Utility and health-care stocks were even more buoyant, with the Dow Jones Utility Average rising 45% and Merck up 39%.
To be sure, wealth has been lost, but more important, it has been shuffled. At the end of March, Microsoft, Cisco Systems and Intel were the first, second and fourth most-valuable companies in the U.S. At the end of the year, Cisco was fourth, behind General Electric, Exxon Mobil and Pfizer; Microsoft sixth, behind Wal-Mart Stores; and Intel 10th, behind Citigroup, American International Group and Merck.
It was a humbling year for bulls. Lehman Brothers’ chief investment strategist Jeffrey Applegate, whose bullishness on stocks, and technology in particular, had served his clients well through the late 1990s, titled a report in November, “Mea culpa.” In March, he considered pulling back on his technology recommendation, but “I just decided I’m a rotten sector rotator, so why bother.” But since March, excess greed has turned to excess fear, and Mr. Applegate thinks technology will come back.
Valuations have been corrected, and the high-priced stocks still standing, like Cisco and EMC, both now at about 100 times trailing earnings, can remain high-priced for years just as International Business Machines, Xerox and Polaroid did for most of the 1960s, he argues. Mr. Applegate thinks overall corporate profits will grow 7% this year, and he predicts demand for technology will again outpace overall economic growth.
If he is right, then the long-term bull market that many think began when inflation was tamed in the early 1980s is still intact. [The bear market in 1990 was one of the shortest on record.] Between 1980 and 1999, the Dow had only three down years — 1981, 1984 and 1990 — as did the S&P 500 — 1981, 1990 and 1994. The year following each witnessed double-digit returns.
But there is a school of thought that last year might mark the beginning of a long stretch of dismal stock returns. The market’s price/earnings ratio rose from 14 in 1990 to 28 in 1999, which means the profit investors demanded for every $100 in stocks fell to $3.50 from $7 over the same period. At the same time, corporate-bond yields fell. Combined, this meant the cost of capital plummeted. That, argues Ben Inker, director of asset allocation at Boston money manager Grantham, Mayo, Van Otterloo & Co., meant rational companies made investments that posted ever-lower returns.
“If P/Es remain high, it means companies have a permanently low cost of capital [which] is only consistent with a permanently low return on capital. It’s how capitalism is supposed to work.”
In fact, returns on investments — whether in specialty retailers, sport-utility vehicles, semiconductor-fabrication plants or broadband networks — were quite high because demand has been so strong. But late last year, overcapacity began popping up throughout the economy and demand slowed sharply, and sector by sector, profit margins are being squeezed. “Certainly AT&T and Lucent are the casualties today,” says Mr. Inker. “But all the way along we are seeing companies finally coming to the realization that if you have huge increases in investment and therefore capacity, that is horrific for profit margins.”
For the current decade, Mr. Inker is bullish on the economy, but thinks stocks overall, in part because of their still historically high P/E ratios (especially in technology), will return next to nothing in the next 10 years, after inflation.
And what if the economy does stumble? The falling stock market has pinched household wealth and raised the cost of capital, endangering both consumer spending and investment. Mr. Bernstein of Merrill thinks profits could actually fall this year, although declining interest rates could offset the impact on stock prices.
In fact, rate cuts are historically one of the most consistently bullish signals. According to Ed Keon of Prudential Securities, stocks have returned 20% annualized on average during 12 easing periods since 1953, and in only two were stocks lower six months after the first rate cut.
Furthermore, the bear market in small and “value” stocks — those with low prices relative to earnings or book value — began back in 1998. They hit bottom early last year, just as the technology bear market got going. “Knowing the market’s tendency to return to the mean, value investors will be the ones who make the most money in the next few years,” says Robert Farrell, Merrill’s senior investment adviser.
But technology stocks won’t recover until their current owners give up on them, he says. At the peak, some 75% of the money in Fidelity Investments’ sector funds was in technology, and that had only dropped to 58% by mid-December, he says. “I would look for that to go down maybe to 30% or 40%” to represent a bottom in sentiment.
Another sign of capitulation will be when Wall Street tells people to avoid technology stocks. On that front, Mr. Farrell has spotted some early signs. On Friday, Dec. 15, eToys warned holiday sales were dismal and said it might not survive on its own. The following Monday, ABN Amro analyst Kevin Silverman put a sell recommendation on the stock — at 28 cents, down 99.7% from its all-time high.