Amid The Gloom, Pockets Of Strength

Most investors have slowly come to the realization that the Nasdaq will not be trading at new highs by the end of 2001. Figure 1 shows the top six declines in the Nasdaq since its inception and the length of time from the high to the low and from the low back up to the high. As you might have expected, the more severe the correction, the longer it takes to recover to the previous highs. This rule of thumb suggests that at this rate, the Nasdaq may take years to reach 5132 again.

Why weren't more investors prepared for the inevitable decline? Unfortunately, no one knew when the excessive optimism would end (and those who did try to predict the end failed miserably). Investors were in denial, forcing themselves to believe we were not in the midst of a mania but that the old standard by which to value companies was outdated. Buzzwords such as "new economy" and "old economy" appeared, and the longer the trend continued, the more people bought into the idea that now was different from before. Trends reverse when the majority of investors have migrated to one side of the market and no one is left to push the market higher or lower. These manias, which have been well documented all the way back to Tulipmania in 17th-century Holland, can bring company valuations far off their intrinsic values for sustained periods. For example, when Yahoo! was added to the Standard & Poor's 500 index, its capitalization increased by $30 billion in just three trading days.

Now that the frenzy has cooled, an accurate assessment of the current market environment is that it is N at best N lukewarm. Investors and traders are still licking their wounds from the tech tumble and are no longer eager to buy just any technology stock while the Nasdaq looks for a bottom. Until the series of lower highs and lower lows ends, there is no telling how low the Nasdaq will go. The fear that usually accompanies major bottoms is simply not present N yet. When the index finally does begin to rally, it will face an uphill battle with much overhead supply (in the form of investors who will be eager to sell into any rally to break even on losses). These reasons will contribute to the Nasdaq remaining deeply entrenched.

This grim assessment, however, is not meant to convince you that there is no compelling reason to invest in stocks today; there remain pockets of strength that are still likely to cushion traders' portfolios. To find these pockets, however, we must understand why the tech sector rose and fell in such dramatic fashion.

THE RISE AND FALL OF TECH STOCKS

From late 1998 through March 2000, the primary drivers for the runup in tech valuations were sales, earnings, and growth prospects. Technology companies kept beating earnings estimates and sustained several quarters of strong earnings and sales growth. Investors latched onto those numbers and projected possible valuations based on unrealistic annual growth rates, which fueled the buying frenzy.

As long as the market was rising, insane valuations could persist indefinitely. The dichotomy between old-economy and new-economy stocks was exaggerated, but it was simply not possible for old-economy stocks to suffer and new-economy stocks to be totally isolated, though such arguments were made. After all, the new-economy companies needed old-economy customers. Investors and traders who recognized the overvaluations could not profit from that knowledge, because it made no sense to trade against the trend given that movements were as swift and as strong as they were.

Only when investors began to realize that the economy was contracting and that the contraction would put a strain on the continuation of positive earnings did the bear market finally make its presence known. Suddenly, companies missed earnings estimates, lowered their sales and earnings guidance for the upcoming quarters (many acknowledging the economy was too uncertain to provide projections beyond two quarters), and gave pessimistic outlooks for their business. Selling begat selling, and abruptly, the market dropped to yearly lows. While history indicates that markets usually post strong gains following interest rate cuts (more on that later), other known factors raise questions about whether that will happen now.

TEETERING ON THE EDGE

The present economy is on the brink of recession. After growing at an annual rate of 8% in the fourth quarter of 1999, US Gdp growth slowed to just 1.4% by the fourth quarter of 2000. The manufacturing sector is in a decline and the US appears to be sliding into a prolonged period of contraction. Whether this gloomy prediction comes to fruition hinges on consumer spending, which in turn depends on consumer confidence and prices. Inflation is not a concern, since it is below 3% and not rising quickly. The primary driver of consumer spending today is consumer confidence. If consumers decide to rebuild their savings in the face of declining wealth as equity prices fall, a deep and prolonged recession will be inevitable. Consumer confidence, as measured by the Michigan Consumer Sentiment index and the Conference Board, fell to its lowest level in more than four years in January 2001. More information on consumer confidence can be found at www.working-money.com.

THE FED TO THE RESCUE?

Interest rate cuts are the only hope for saving the US economy. However, according to Federal Reserve chairman Alan Greenspan in his speech to the Senate Banking Committee in early 2001, the Fed is unlikely to be as aggressive in easing interest rates as it appeared in January when interest rates were cut by 100 basis points. Greenspan indicated he did not believe the economy was in a recession and despite the slowdown witnessed in the fourth quarter of 2000, recent economic reports (such as retail sales and new housing starts) indicate a resumption of growth. In addition, Greenspan pointed out that analyst earnings estimates for the next five years have not come down significantly and are still very high.

That in itself is troubling. Observes Jeremy Siegel, finance professor at the Wharton School of the University of Pennsylvania, "Many analysts have simply not lowered longer-term earnings estimates because of the uncertainty of the economy." Greenspan has been slow to cut rates before; once in 1990, our last recession, and in 1998. The chances of a recession are at least 50%, and the Fed appears to be acting too slowly to combat it.

The Fed's policy meeting in the early part of 2001 did little to allay fears of a coming recession. The 50-basis-point cut announced in March had little effect, as the markets had long anticipated the move and adjusted for it. The Fed should be concerned because the weakness in equity prices is depressing consumer confidence.

Herein lies the conundrum: Greenspan does not want to give the appearance he is easing rates to relieve stocks, since the Fed's stated policy is to ensure price stability and economic growth. However, it is becoming clear the stock market, especially when generating significant positive or negative returns, affects consumer behavior, which influences the economy.

We cannot fault the Fed for not moving quickly enough; if at all, we must fault it for not learning from its own mistakes. A situation arose similar to the current one as recently as 1994. At the time, inflation was creeping in and the economy was heating up, which required Fed policymakers to raise interest rates. But instead of acting decisively, the Fed raised the fed funds rate slowly, starting from 3% and creeping up in 25-basis-point increments. It gradually became clear that the market wanted a quicker response than such tiny, uncertain steps. Eventually, the Fed was forced into a corner when it spiked up the fed funds rate, leading to the worst bond market climate in 50 years.

Today, we face a similar situation. Only now, instead of inflation being a threat, recession is. The market wants the Fed to ease interest rates faster, as is apparent in the June fed funds futures contract. Before the March 20th 50-basis-point easing, the contract was anticipating that the fed funds rate would move down to 4.56% by June. After the announcement, the estimate fell to 4.44%. The market is indicating it does not believe the Fed is taking necessary preventive measures to avoid a recession, and like 1994, will be forced to take extreme measures.

The only bright spot in all of this appears in Greenspan's wording in the statements accompanying the March 20th rate cut: "In these circumstances, when the economic situation could be evolving rapidly, the Federal Reserve will need to monitor developments closely." This statement appeared in the Fed's December 2000 meeting, which was followed by a poor National Association of Purchasing Managers (Napm) report that led the Fed to cut interest rates. The statement, interestingly enough, was not repeated in the notes accompanying the January 31st interest rate cut and so no intermeeting cut followed. Now, however, with the next meeting not until May 2001 and Greenspan's hint present, there will most likely be a 25- to 50-basis-point cut sometime in April.

CONCLUSION

Don't fight the Fed or don't fight the trend? Usually, we do both, but today, this presents a contradiction and we must default to the latter. Technology stocks, those darlings of yesterday, will likely be range-bound for a few years and be better short-term trading vehicles than long-term investments.

As the analogy goes, if you place a frog in a pot of boiling water, it will immediately react by jumping out of the pot. However, if you place it in cool water and slowly turn the heat up, you can boil it alive. The Nasdaq's current descent is similar to slowly heating the pot. We won't reach the bottom until there is a huge change in temperature (that is, capitulation) and everyone moves to one side of the market.

Generating healthy returns in times of uncertainty relies on a presence in the right sectors or trading the right type of stocks. Few sectors are going against the tide, but the oil and retail groups offer opportunities for those willing to take quick profits. Value stocks are also significantly outperforming growth stocks N and given the state of the economy, this trend is likely to continue. Investors and traders should concentrate in these areas of the market. After all, you are much more likely to move quickly if the wind is at your back.

Omar Bassal is a first-year MBA student at the Wharton School of the University of Pennsylvania and an affiliate member of the Market Technicians Association. He has breathed, dreamed, and lived stocks since he first began trading in the early 1990s. He can be reached via e-mail at bassalo@wharton.upenn.edu.

SUGGESTED READING

Gopalakrishnan, Jayanthi [2001]. "Let The Buyer Beware," Working Money, Volume 2: May.
Siegel, Jeremy [1998]. Stocks For The Long Run, McGraw-Hill.

Copyright © 2001 Technical Analysis, Inc. All rights reserved.