Stalking The Bull

By Daniel Kadlec

Like Harry Potter peering into the mirror of Erised, investors examining this wacky stock market can see exactly what they want to see. The fumbled election? Terrible news, say the grim. No clear winner; no telling what's in store. Wonderful news, say the glib. So much confusion means so much gridlock in Congress that we'll probably not get any dumb spending bills or tax cuts. Read: The surplus is safe.

It's important to look beyond the election, though, because its bizarreness is merely masking a market that is already more confused than a Palm Beach voter. Equally ambiguous are readings of the economy, dollar and investor psychology.

Take the economy. Everyone knows it's slowing and that corporate profits will fade in tandem. Bad news for stocks, right? But wait. With inflation tame, the Federal Reserve has room to lower interest rates, prevent a recession and kick off another bounteous period of accelerating growth.

The strong dollar? It diminishes the value of foreign earnings and makes U.S. goods less attractive abroad, hurting multinational companies like Gillette and Goodyear. But it's also luring tons of foreign investment to the U.S., putting a floor under stock and bond prices.

As for investor psychology, it has turned circus-freak ugly. Not a serious buyer in sight. Cash is piling up in money funds, which stand at a record $1.8 trillion. Cash at stock mutual funds equals 5.3% of assets, up from 4% in March. Yet to bulls, these stockpiles represent buying power ready to push prices higher. "I've never seen so many people on Wall Street talking to so many other people on Wall Street trying to figure out what's happening," confesses John Manley, a market strategist at Salomon Smith Barney.

And these are the professionals. As you've probably heard by now, the stock market, like some dim-witted clerk, applies a generous markdown to what it can't figure out. Thus the NASDAQ index fell 12% during election week and plunged again last Monday, crashing below 3000. It bounced back on Tuesday but was dishearteningly choppy the rest of the week. The Dow has been on its own treacherous sawtooth course, breaking the will of many who had expected a year-end rally to take shape by now.

The rally may yet come. As noted, the bulls can make a case, one largely hinged on lower interest rates. But for now, rates are steady, and the bears are in control. Long-term investors may want to start building positions. Don't be surprised, though, if tech bellwethers sink more before a sustained recovery. That's especially true of those with rich valuations like Cisco and fiber-optics darlings Corning and JDS Uniphase.

Forget the profitless dotcoms. Better to hunt for beaten-up telecom stocks like Verizon and WorldCom, which are now popping up on the screens of dyed-in-the-wool value managers. The tech tortured can seek solace among energy services, banks and insurers, consumer staples and health care. Stay diversified and somewhat conservative. An all-purpose growth-and-income fund might be just the thing. Bonds are also a decent place to hide while the market is seeing a dark cloud behind every silver lining.

For most of the past few years, investors ignored what was worrisome and considered only good news. That probably kept stocks moving higher for longer than they should have. Now the focus is on negative factors, and that too could go on longer than it should. Front and center is the zaniest election ever. Few believe we're headed for a crisis, but reflecting on the possibility has prompted relentless selling.

Does that make sense? Not on the face of it. But some investors evidently took a second look at what they owned and found a slew of tech stocks that have been sinking since last spring. Worse, even at these new lows the stocks remain priced for perfection in an environment rapidly turning anything but.

The NASDAQ is down 40% from its all-time high and down 26% for the year. The Dow and broader market gauges are down for the year too. With so much damage on the books, it would require superhuman restraint by investors not to greet future rallies with some selling in a bid to get even and get out, or just take some risk off the table.

The Fed didn't help matters on Wednesday, when it left interest rates unchanged, as expected, but then squashed a buoyant market that day by noting that it remains more likely to raise than lower rates in the near future. Economists still expect a rate cut by June. But the Fed added oceans of uncertainty to a market already drowning in it.

The list of what ails Wall Street is long, and not all items are easily dismissed. It's hard to find something great about oil at $30 per bbl., for example. The world is less dependent on oil than it was 20 years ago, and so far the higher costs haven't stoked inflation. But the risk of a severe global slowdown is greater when energy is expensive, and few outside of OPEC, Big Oil and the guy selling home insulation ever gained a lick from rising energy costs.

More worrisome is a broad slowdown in the crucial area of tech spending. It's no secret that tech is the ox that for years has pulled the market higher. Other industries, including retail and autos, are already in profit recessions. Without a vibrant tech sector, there is little to drive overall corporate profits higher.

Barton Biggs, chief global strategist at Morgan Stanley Dean Witter, notes that spending on telecom equipment will be down in 2001, after rising steadily for years. A number of big carriers have already disappointed Wall Street with weak sales of their goods and services. Spending on PCs and by cable systems is falling too, Biggs says. Meanwhile, recent dotcom failures and near failures, from Pets.com to Drkoop.com highlight that industry's capital crunch, which will take a big bite out of revenues at suppliers such as Sun and Oracle; the latter's stock is down more than 40% in three months.

Cascading tech values are leaving a lot of investors feeling queasy. Michelle Jorgenson, who trains social workers in Chicago, halted plans to buy a cabin hideaway when the value of her mutual funds sank $9,000 in October. Pamela Green, a dotcom marketing executive in Atlanta, saw her down-payment kitty sink from $10,000 to $7,500, and instantly put the brakes on a condo deal. "I have a lot of expenses, and I'm not hearing anything from clients," she says. "I'm going to hold off on spending. My mother always taught me to have some money that I call my God-forbid money, and I've already had to dip into it."

In nearby Smyrna, Ga., Greg Jackson, a gas-station owner, puts it succinctly. "I've lost my tail," he groans. "I gambled and lost with tech stocks." After holding only blue chips for a decade, he jumped into Internet stocks a year ago, near the peak of dotcom mania. Now he's investing in land and his business--and spending less.

Such anecdotes help fill out the market backdrop. Since March, $2 trillion of market value has been wiped out, and if you believed in a wealth effect on the way up, then you have to believe in it on the way down. People spend less when their savings evaporate. They spend less when it will cost 30% more to heat their home. No wonder retailers are anxious about Christmas. Beyond that, the possibility of a recession next year has crept into the stock market. That's going to make sustainable gains hard to come by. Like Harry Potter and his magic mirror, you can see what you want. Just remember that what you see may not be real.

--With reporting by Matt Baron/Chicago and Collette McKenna/Atlanta

With reporting by Matt Baron/Chicago and Collette McKenna/Atlanta