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Retro Fashion For The New Market

Where to Invest -- Strategies for Stocks

Retro Fashion for the New Market

As rates ease, non-tech plays show promise

New Year's salutations usually sound an "out with the old, in the with the new" theme. But for stock market 2001, it may well be an "in with the old, out with the new" kind of year.

The Nasdaq, weighted largely with New Economy technology stocks, will probably end 2001 flat or slightly up--better than the 28% loss so far this year but a long way from its 40% average annual returns of the past five years up until March, and a far cry from the many bullish predictions on Wall Street. On the other hand, the Standard & Poor's 500-stock index, which has a 75% weighting in nontech and Old Economy stocks, should rebound and could score a neat double-digit gain. Sure, as the economy continues to slow, earnings will be a problem for many companies, and the market next year will be tough. But there's good news on the horizon: an easing interest-rate environment; oil prices that have likely peaked; and accelerating money-supply growth, or increased liquidity, in the market.JANUARY RALLY? Lower interest rates will more than offset the effect on stocks of a slowing economy and dwindling earnings growth. With Wall Street expecting the Fed to ease by as much as 50 basis points by March, many expect a rally as early as January. John L. Manley Jr., chief equity strategist at Salomon Smith Barney, says the market has been focused on economic deceleration, overlooking "the bright side of a slowing economy--lower interest rates."

Growth stocks tend to fare best during the first six months of a rate-easing environment, according to Edward Keon Jr., Prudential Securities Inc.'s chief quantitative strategist. Keon recommends companies in what he terms "growthier" industries--that is, areas that are growing faster than others. Among his picks: retailers Home Depot (HD), Wal-Mart (WMT), Intimate Brands (IBI), and Gap (GPS), as well as sectors such as bank stocks, building supplies, and air freight, which also tend to do best when rates are being cut. And although tech is considered the ultimate in growth and historically has benefited from rate reductions, Keon warns: "You may have two strikeouts and two home runs." That's because many tech stocks remain highly valued and their earnings expectations continue to be slashed. Also, the sector's sharp volatility is likely to worsen.

Earnings estimates for the S&P 500 also continue to be revised downward--analysts predicted 14.8% growth for 2001 in early October, vs. 10.6% now, according to First Call Corp., the earnings research firm. First Call expects more negative earnings warnings from companies in early January. But tech stocks in particular will continue to be hit the hardest. In early October, tech earnings were expected to increase 24% next year; now forecasts are for only 15% growth. And investors likely will continue to punish richly valued tech stocks with lower earnings. "The magic is gone from the Nasdaq. And since there are still no overwhelming values compelling investors to buy these stocks, it won't be a great place next year," says Jeremy Siegel, finance professor at the University of Pennsylvania's Wharton School. The price-earnings ratio on a 12-month trailing basis of the Nasdaq Composite Index is 120. But that's still much higher than the average over the past five years of 92.

Valuations for the S&P 500 are a different matter. "S&P 500 multiples look the most attractive in almost two years," says Christine Callies, chief U.S. investment strategist at Merrill Lynch & Co. Callies predicts the S&P will end 2001 around 1720--about 22% higher than its current level. More good news for the S&P 500: Since the Nasdaq correction last March, the market has continued to broaden as investors have poured money into a more diversified group of stocks.

A beneficiary of this broadening has been small- and mid-cap stocks. So far this year the S&P MidCap 400 index has returned 19%; the S&P SmallCap 600 index, 7%. And these stocks, too, tend to benefit from falling interest rates. "Because they have less liquidity, these stocks improve the fastest and most dramatically in a rate-easing climate," says Steven G. DeSanctis, director of small-cap research at Prudential Securities. And Goldman, Sachs & Co. strategist Abby Joseph Cohen issued a recent report lauding the relative valuation of smaller issues which "sets the stage for solid price appreciation."

It's not all bad news for the Nasdaq. Tech stocks will also benefit from rate cuts. And some say the index has bottomed. "The fact that techs rallied the week following Intel's (INTC) Dec. 7 earnings warning was a sign we're bottoming," says Charles W. Kadlec, chief investment strategist for Seligman Advisors Inc. Another sign: The equity call/put ratio, a contrarian market indicator, recently dropped to its lowest level since October, 1998, signaling a market upturn.GRIDLOCK. Of course, the election aftermath could loom over the stock market for much of 2001, as the legitimacy of whoever takes office is called into question. Congressional gridlock has been lauded by Wall Street as positive for the market, because no extreme proposals from either party would likely gain approval, but it still means uncertainty, which the market hates.

So what's the best strategy for investors next year? First, they may want to revisit that age-old concept of diversification. With investors having poured billions into tech stocks in the past two years, many portfolios are tech top-heavy. "You need different asset classes and sectors to minimize volatility. But that doesn't mean you can't still have a leaning toward growth," says Russ Ketron, a Novato (Calif.) financial planner Some broad areas to consider: small- and mid-cap funds, equity-income funds, and trusty S&P funds.

In terms of growth plays, the best strategy is to look for strong, sustainable growth coupled with attractive valuations. "Over the next few years we think p-e's will not rise, so more moderately priced growth stocks will have the advantage," says Merrill's Callies. What about those tech stocks, whose prices have come down? No dice, says Callies, who says memories of this year's debacle are still fresh. Seems like old times again.By Marcia VickersReturn to top

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