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Rates Start to Bite
Though other forces pounded stocks, interest rate hikes were key
For weeks, the markets confounded the conventional wisdom--that rising interest rates had to produce falling stock prices. As the Nasdaq, the Dow, and the Standard & Poor's 500 all hit new highs in December, people began to wonder if the New Economy had wiped out another Old Economy rule.
Then came the new year. On the first trading days of 2000, interest rates took center stage. And with the spotlight on the long-bond yielding 6.6%--the highest in 27 months--and the odds of a Federal Reserve rate hike rising, too, investors took out the old rule book and sold. With a vengeance. The major U.S. indexes and bourses around the world tumbled by as much as 7%--prompting anxiety that the long-feared bear market might be getting under way.
But despite the apparent free-fall of the Nasdaq, no such danger is present--yet. If rates stay where they are or tick up a bit, the market will most likely weather the storm. Indeed, rosy corporate earnings may lead the market even higher. And the markets may already reflect what is emerging as a consensus on the Fed's next move at its February meeting: A hike in the discount rate by as much as a half-point. This is aimed at cooling an economy that likely grew at a too-hot 5% rate in the fourth quarter and is seeing signs of commodity price inflation. A second hike at the subsequent meeting is also widely expected.
That implies long rates of 7%, which certainly does not come under the heading of good news. Even now, the reversal of the markets may have choked off the broadening that had just begun. For, after a year during which only a few spectacular issues--mostly in tech--propelled the indices, in the last weeks of 1999 more small- and mid-cap stocks joined the runup. Now, many of those issues, especially Old-Economy-style equities which are sensitive to interest-rates, have fallen behind again.
Rates aren't the only factor in the sell-off. Some of it was simple first-of-the-year profit-taking by investors who wanted to slough their huge capital gains into a new tax year. That affected the high-flying Nasdaq, in particular. The Nasdaq, which posted an 86% gain in 1999 thanks to a yearend surge by large-cap tech issues such as Qualcomm, was also ripe for revaluation: The Nasdaq 100, the largest issues on the exchange, were valued at a staggering 130 times earnings at yearend.BLAHS-BUSTER. Another factor in this witch's brew: With the economy safely past the Y2K hurdle, the Fed is draining the extra liquidity it had injected into money markets as Y2K insurance. Many now suspect that, just as initial injections more than a month ago began to push the market up, so the withdrawal took the steam out of the rise.
Above all, however, looms the specter of higher interest rates. "You can't shake the fact that a lot of investors are worried about rising rates," says John L. Manley Jr., Salomon Smith Barney's chief market strategist, who on Jan. 4 reduced the firm's equity position from 60% to 55% and increased its cash position from 5% to 10%.
Even so, the market could well shake off its New Year's blahs. For one thing, annual earnings for the S&P 500 stocks for 1999 will be reported in the next few weeks and analysts expect them to come in 15% over the year before. Profits at technology companies, such as Microsoft Corp., are expected to jump an incredible 42%.
Moreover, the relationship between interest rates and equity values may be changing--at least when it comes to New Economy stocks. Companies such as Amazon.com Inc. and CMGI Inc.--big factors in the Nasdaq 100--have yet to post earnings. Their growth potential alone has spurred higher prices. "You've got an amazing number of investors who are buying these tech stocks and are relying solely on momentum and growth prospects. Interest rates barely enter into the equation," says Laszlo Birinyi Jr., who runs his own research firm and serves as global strategist at Deutsche Bank Securities Inc.
Another reason tech stocks won't be hit as hard by rising rates long-term, says Birinyi: Many tech companies--and Internet companies in particular--don't go to market to borrow capital. Instead, they rely on venture capitalists and lucrative initial public offerings. "There are so many elements of this equation that are different from the classic business model of 50 years ago," he says.
So, for some investors, Nasdaq dips accompanying rate increases merely present buying opportunities. Over the past six years, according to MarketHistory.com, an investment-research firm, whenever the 10-year Treasury note yield has risen 10 basis points, in the following four days the Dow, the S&P, and Nasdaq have dipped 2%. But in the subsequent four days, the Nasdaq Composite rises more than 7%, while the S&P and Dow go up only 4%.
Where rising rates will cause the most blood-letting is in the already downtrodden value sector, where interest-rate-sensitive stocks such as John Deere and General Motors lurk. Indeed, rising rates could derail the fledgling comeback of these stocks, which have once again shown signs of life, thanks to an improving global scenario. In fact, rising rates could crimp the broadening of the market that began in the fourth quarter, when many stocks outside of the S&P 500 performed exceedingly well. For the year, for instance, the Russell 2000 Growth and Mid-Cap Growth Indexes posted gains of 43.08% and 51.3%, respectively, outstripping the Dow and the S&P.
But inside the major indexes, the performance remains narrow. Only 25 stocks, including Microsoft and America Online Inc., were responsible for the entire gain in the S&P 500 last year on a market-cap-weighted basis, according to Salomon Smith Barney. "This has created a bifurcated market where only the top tier of the S&P is performing, [along with] growth stocks that are too small to be part of the S&P," says Gerold F. Klauer, founding partner of Gerard Klauer Mattison & Co., a New York investment firm.
In the end, no matter how much good news you try to dredge up, much of the markets' future rests with the Fed. After an exceedingly strong Jan. 5 report on November factory orders, Wall Street strategists and economists agree that the Fed will almost certainly raise rates at least 25 basis points in February and maybe as much as 50. "The Fed wants to dilute the punch a little bit, but they don't want the party to end," says William C. Dudley, chief U.S. economist at Goldman, Sachs & Co. And many, including Dudley, insist that at least one, and possibly two, hikes have already been priced into both the stock and bond markets.
In fact, now that Y2K has passed without incident and the economy appears to be more and more robust, many economists believe that the Fed could tighten a third and even fourth time, especially if the stock market resumes its meteoric rise after this current pullback. "The Fed is increasingly looking at the market as a key inflation indicator. And it should: The stock market has a $14 trillion market cap versus a gross domestic product of $9 trillion. But 10 years ago, the stock market was only half of the GDP," says James A. Bianco, who runs Bianco Research in Barrington, Ill. And most Wall Street strategists, including super-bull Abby Joseph Cohen, are saying that the tech and telecom sectors, in particular, should see less dramatic growth going forward.
Perhaps more importantly, Fed Chairman Alan Greenspan has repeatedly voiced concerns over the euphoric, speculative nature of the stock market. "Put it this way, if there's a battle between the stock market and the Fed, the Fed will tighten until it wins," says Salomon Smith Barney equity strategist Jeffrey M. Warantz.
Still, as for derailing highly valued U.S. tech and telecom stocks, experts say interest rates would have to climb to a "psychologically significant" level and stay there to have a profound effect on the market. "Yields must go up a lot in order to be competitive investment alternative to stocks," says Bianco.
Bianco's magic number? He thinks 7% possibly, but 7.5% definitely would hurt the highfliers. And while that was unthinkable this time last year, he is forecasting that rates will peak at 7.5% by midyear. "Once you go over the top and interest rates are so high that they actually start to hurt value stocks and the economy, then the prospects of an AOL or Yahoo! Inc. are in big trouble," he says.
In fact, rising rates may already be causing a "flight to quality" in tech stocks: That is, investors are willing to bet their money only on stocks with proven earnings and track records. "When rates rise, we're seeing a dramatic switch from the clickable world into blue-chip tech stocks like Motorola and Dell," says William B. Noble, market strategist at MarketHistory.com.
And that means that interest rates still count, no matter how much New Economy thinkers and strategists may want to ignore them.By Marcia Vickers in New YorkReturn to top