Zap!

By Daniel Kadlec

Let's start with some comforting news: a lot of stocks are doing well. Despite awful headlines and a palpable fear, the average diversified stock fund has fallen a manageable 13% in the past year. Meanwhile, if you owned Philip Morris, Duke Energy and Ralston Purina in that period, you made money. Good money. Of course, those stocks killed you the two years before that, so nobody really loaded up with them. Still, it's a mistake to assume that everyone is losing his shirt in this bear market.

Lots of people are doing well too. Job creation is growing at a faster pace this year than in the final months of 2000. Inflation is tame, and interest rates are falling fast, lowering the cost of mortgages and car loans.

Still, for those of you who got creamed in the stock market last week, here's a little more comfort: you've got company. Lots of it. Such meager solace won't put Junior through college or send Cisco back to $82, but it sure helps the ego knowing that tens of thousands of people clung to their tech stocks as desperately as you did for the whole bloody decline. How could they not? For years tech stocks were magical. Unimagined wealth was yours simply for logging on to the New Economy mind-set, clicking three times and whispering, "There's no place like a good home page."

Boy, did we buy that line! From the end of 1997 through March 2000, some $112 billion flowed into aggressive growth stock mutual funds, the kind that load up on the Yahoos and Akamais. Investors anted up $52 billion to buy 585 tech IPOs during the same period--roughly the same amount spent on twice as many deals over the previous eight years. At the peak, just over a year ago, tech stocks accounted for 35% of the S&P 500's market value, up from 12% in 1995. It was a mania for the ages, and you were in the front row.

So where are all the dreamers now? Did someone ring a bell saying the jig was up, time to cash out? Nope. They never do.

Jose Aguayo, a New Jersey-based energy analyst, was one of those believers. He lost thousands in Lucent and WorldCom shares. "I felt very silly," he says. And chastened. Now the splurge money is gone, and Aguayo says he won't be going back into stocks anytime soon. His experience is common. Vaporized stock-market wealth is at $4 trillion and counting. The losses have engendered one of the fastest economic decelerations ever--from an annual growth rate last spring of 6% to near zero today. In a $10 trillion economy, that's a difference of $600 billion.

Right now, it's more important that folks like Aguayo buy socks--and shoes, and televisions and airline tickets--than stocks. Despite all the stock-market noise, consumer spending is still the linchpin of the economy. And scared consumers sit on their wallets. "We do not believe we are in a recession. But the economy is vulnerable to a decline, and the consumer is the key to preventing a decline," notes Steve Young, the director of asset allocation at Banc of America Capital Management in St. Louis, Mo. Want to help? Buy something. Buy two.

A great debate rages as to how the consumer drama will play out. The worry factor is not to be underplayed. Recessions and bear markets are as much about psychology as fundamentals, which is precisely why the stock market--unable to find something it can believe in--has worked up such a sweat. To that extent, the media may be fueling the pessimism. In January, TIME put the worried faces of a family of four on the cover and expounded on HOW TO SURVIVE THE SLUMP. More depressing has been the recent stream of daily headlines about plunging stock prices. And in a high-risk bid to win support for his tax cuts, President Bush has been sounding alarm bells that reach into every kitchen.

Indeed, both parties are trying to score political points from the economy's troubles. House majority leader Dick Armey is pushing for a higher tax cut than the $1.6 trillion Bush has proposed. The slowdown makes it more likely that tax cuts will come quicker and be retroactive to Jan. 1. But sliding stocks will make Bush's plan for Social Security accounts--ostensibly for stock investing--a tough sell.

Democrats are quick to blame Bush, claiming that all his talk of a worsening economy created a self-fulfilling prophecy. "The Bush Administration has been talking down the economy for some time," claims Senate minority leader Tom Daschle, insisting that consumer confidence dropped every time Bush or top aides gave gloomy forecasts--in November, when then vice presidential candidate Dick Cheney announced, "We may be on the front edge of a recession"; in January, when Treasury Secretary Paul O'Neill said, "There is no doubt that we are experiencing a slowdown"; and in February, when Bush claimed that "a warning light is flashing on the dashboard of our economy."

All this tea-leaf reading, and no one knows for sure if we will actually get a recession. One thing we do know: stocks are in their worst rout in two decades. The Dow's all-time high of 11,723 came on Jan. 14, 2000, and it has since fallen 16%. That's nothing compared with the 25% decline since last March in the more tech-exposed S&P 500. The tech-laden NASDAQ has plunged 63% since its peak a year ago, the worst drubbing for a major stock index since the Depression.

Most alarming last week was that the Dow, which had been weathering this typhoon rather well, took the biggest hit--falling 821 points, or 8%. If the selling spreads, Philip Morris and other recent gainers may be the next to tumble as worried investors take winning chips off the table.

Despite the sell-off, the probability of a repeat of the crash in 1987 remains low, says David Blitzer, chief investment strategist at S&P. Still, preceding that crash "we had a high volatility week and a high-anxiety weekend," he notes, adding that the current environment feels a lot like that. And so far there has been no cathartic sell-off, just a steady exodus, mainly from tech stocks. Market watchers would like to see capitulation--a panicky selling spree that flushes out all the worrywarts and sets the stage for the next bull market.

The staggering amount of lost wealth over the past year is perhaps the most oppressive development. Half of all households own stocks, up from 4% in the early 1950s. Stocks account for about 20% of total household assets, and because stocks fell last year, the net worth of the average American declined for the first time since 1945, according to the Federal Reserve. In the past six months, the market value of household stocks and stock funds fell more than $2 trillion--roughly the same amount of money households earned through wages.

For sure, much of the lost money was the easily coined spoils of a long bull market. In that sense, all a lot of people really lost was the casino's money. Still, it's causing consumers to pull back somewhat. Retail sales went negative in February, a third drop in five months. Consumer confidence is at more than a four-year low. Any further market losses could multiply the gloom exponentially because, with the NASDAQ at a 2 1/2-year low, the casino's money is about gone. The next dollar lost for many will be money earned at work, not in the market.

"There are all kinds of unforeseeable and unintended consequences of what's going on," says Barton Biggs, chief global strategist at Morgan Stanley Dean Witter. He's especially dour on the economy, saying corporate earnings will fall 20% this year and that before it's all over we will have a full-fledged recession with bouts of Japanese-style deflation. He's less worried about the stock market, though, believing a rally is imminent. (For more on his bearish view, see Personal Time: Your Money.)

There's also some doubt that Federal Reserve Chairman Alan Greenspan can ride to the rescue with another rate cut. "He's a gradualist. Each little step is expected, and there's never any surprise, so cumulatively there's no impact on the psychology," argues Michael Murphy, editor of the California Technology Stock Letter. Last week the market was begging for an interest-rate cut beyond the half percentage point already factored in. The Fed cut rates twice in January a total of 1 percentage point.

Yet the corporate spending slowdown continues unabated. Merrill Lynch projects that business spending on equipment and software will rise only 4.5% this year--the weakest showing since the last recession, in 1991. On Friday the government reported that industrial production dropped for the fifth month in a row. "People are counting too much on the Fed," says Ken Shea, head of stock research at S&P. "The cost of capital is not the issue. The corporate executives do not want to spend right now." After huge technology investments in the past 10 years, many companies have all the firepower they will need for a while, he says.

If all this gloom has you ready to cash in your stocks and put the money in a mattress, stop right there. The critical link between the stock market and the economy is this: the stock market always looks ahead. The barrage of poor earnings, layoffs and dismal headlines that has driven stocks to this low point is over. That's not to say there won't be more negative news; there almost certainly will be. But at some point the stock market will have anticipated the worst and begin to move higher, even in the face of recession-like conditions.

Is that time at hand? A lot of people think so. "The broad economy is not as bad as the technology economy. More people are starting to wake up to the fact that this is a technology problem," says Thomas McManus, portfolio strategist at Banc of America Securities in New York City. Certainly there are hopeful signs. Consumer-sentiment figures released by the University of Michigan Friday suggest that the pessimism may be leveling off. Car and home sales have held up reasonably well, drawing down inventories, a critical issue. Consumers have been refinancing their homes at the fastest clip in several years. Energy prices have stabilized. Despite a rash of announced layoffs, the unemployment rate remains low at 4.2%. And cash is piling up. Mountains of the stuff are accumulating in money funds--a record $2 trillion--presumably waiting to come back into stocks at the first sign of a revival.

Most important: given time, falling interest rates almost always work, and with inflation low the Fed has room to cut away. Why isn't the stock market responding now? "In the early innings of a weak economy there's always a battle between lower interest rates and falling corporate profits, and falling corporate profits always win," says Richard Bernstein, strategist at Merrill Lynch. In that respect, he says, there's nothing unusual about what's happening. Investors are focused on the bad news. Eventually, though, falling rates breathe life into an ailing economy--and into the stock market well in advance.

Since 1921, in 13 cases in which rates were cut swiftly three times in a row, the Dow has been higher one year after the third cut on 12 occasions. A cut this week would be the third this go-round. The median gain in the 13 cases was 25%, according to Ned Davis Research. The NASDAQ, which came into being in 1971, has never been negative a year after a third consecutive rate cut, and its gains have also been impressive.

Stats like that give bullish analysts plenty to talk about. "The economy will be picking up significantly by the fourth quarter," says Bruce Steinberg, chief economist at Merrill Lynch. "Corporate earnings should be picking up at the same time, and the stock market, because it looks to the future, is going to be going up well in advance of that. I really think sometime in the spring the market will turn around."

As for comparing the U.S. economy with the downwardly spiraling Japanese economy, analysts note a host of differences. The main one: the Japan bubble was built on rising real estate values. Banks were heavily exposed through mortgages and commercial-property loans. The U.S. bubble was in a narrow sector of stocks. Some banks are exposed through private equity investments; but for the most part, even if your portfolio tanked, your bank doesn't have much at risk. Healthy banks are vital to a healthy economy.

Macro issues aside, many stocks now trade at bargain prices. Sell now and you risk selling at the bottom. Ironically, a lot of tech stocks now trade higher relative to this year's earnings than they did even before the slide. So they still look expensive. But that's because near term earnings assumptions are falling faster than the stock price. If the earnings slump is temporary, as it most likely will be for blue-chip firms like Intel and Microsoft, the near term outlook should be ignored if you are a long-term investor. A better metric is the expected five-year growth rate.

At times like these it can be hard to hang on to your stocks. No one knows if they will go lower before they rebound. But if you sell now for any reason other than to diversify, you probably shouldn't be in stocks in the first place. They work their magic only over long periods of time.

--With reporting by Bernard Baumohl and Carole Buia/New York, David S. Jackson/Los Angeles, Marc Hequet/St. Paul and Douglas Waller/Washington

Chat with Dan Kadlec about the future of the economy on AOL at 7 p.m. E.T. on 3/21. Keyword: Live

With reporting by Bernard Baumohl and Carole Buia/New York, David S. Jackson/Los Angeles, Marc Hequet/St. Paul and Douglas Waller/Washington