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Investors, "Keep Your Day Job"

The stock market may do "well, but not brilliantly" in 2003, with perhaps a 10% gain in the S&P 500-stock index and 15% in the Nasdaq. So says Donald L. Luskin, chief investment officer of Trend Macrolytics, who bases his forecast on a feeling that investors will be less nervous -- rather than on an expectation of robust profits.

Luskin notes that all stock sectors except technology are still undervalued. And he believes that the value strategy of investing is still preferable to growth. He points out that if you remove techs and telecom from the S&P 500, the index has already recovered to within 3% of its all-time peak earnings.

These were among the comments Luskin made in an investing chat presented Dec. 26 by BusinessWeek Online on America Online, in response to questions from the audience and from Jack Dierdorff and Karyn McCormack of BW Online. Following are edited excerpts from this chat. A complete transcript of this chat is available from BusinessWeek Online on AOL, keyword: BW Talk.

Q: Whatever happened to the idea of a Santa Claus rally?

A: The whole idea of seasonal patterns in the stock market is really pretty ridiculous. You shouldn't expect the market to do any particular thing because of the time of year -- especially now, when there are very powerful news items running the market.

Q: The tech sector has had fits and starts. What do you make of its prolonged slow recovery?

A: The tech sector is really showing no signs of actual recovery. The closest thing to recovery is that it has stopped getting worse -- and that is progress. But we should remember that flat revenues and flat profits are not good enough and will not support the kinds of expectations that investors have for this sector, and the kinds of valuations that investors still put on these stocks. Unless there is true revenue and profit recovery, there will be a lot of disappointment in this sector over the next year.

Q: What kind of market trends do you see for 2003?

A: The stock market will do well, but not brilliantly overall. I would look for, say, 10% on the S&P and maybe 15% on the Nasdaq. However, I would note that, considering the pain that we have suffered in the last three years, I regard those gains as very modest and having mostly to do with investors gradually becoming less scared, not any real progress in profits.

Q: Talk of war with Iraq, and now a conflict over nuclear weapons with North Korea, seems to be taking a toll on the market. Do you think investors will stay nervous?

A: My view is that the market has already discounted many of the costs of war, and that as long as any military action does not produce any large-scale, unexpected costs, it's probably all upside from here with respect to that risk.

Q: Please give your opinion on Citigroup (C).

A: I think all the worst news is out on Citigroup now, and I think they've already paid the worst possible price for whatever it is they've alleged to have done during the boom years. We should now expect that they'll get back on track, and that a stock that has become quite cheap will recover quite smartly.

Q: Beyond Citi, do you like the financial sector?

A: The financials are now the largest sector in the S&P 500, both in market cap and in earnings contribution. So it's very important for the market that this sector do well, and I believe it will. On balance, financial stocks are significantly undervalued, and I believe that the Fed's new commitment to fighting deflation will help relieve a lot of the default risk that has been plaguing the sector.

Q: What's your forecast for Fed policy in 2003?

A: The Fed is beginning to learn that it can only really concentrate on one war at a time, and it has very clearly chosen to fight deflation. That may mean abandoning its policy of the last 20 years of setting interest rates. It may simply let the market set interest rates freely and focus on nothing but maintaining the stable value of the dollar against key indicators such as the gold price.

Q: Do you prefer growth or value investing?

A: I strongly prefer value over growth, because I am forecasting economic recovery, as distinct from strong economic growth. Therefore, the kinds of companies that interest me are ones like, say, GE (GE), which I see as a proxy for the overall industrial economy, and is now trading at a low valuation compared to the insane valuations of the last seven years.

Isn't it ironic that all the pundits were telling you to buy GE when it had a p-e of 30, and now everyone's telling you it's radioactive when it has a p-e of 15?

Q: Many people feel this is the year that bonds will take the big hit after a big runup. Do you agree?

A: Excellent question. The Fed has effectively ended the great bull market in Treasury bonds. However, I am not ready to predict a great bear market. If the Fed's objective is to stabilize monetary policy right where it is now, then bonds could get pegged to a very narrow trading range for the coming year.

We must draw the distinction between Treasury bonds and corporate bonds. Corporate bonds, especially junk bonds, have not enjoyed the bull market that Treasuries have. That's because even though interest rates have been coming down, default risk has been going up. So the spread between junk-bond yield and Treasury yield is almost as high today as it has ever been.

My forecast is that Treasuries will stay pretty much where they are today but that junk yields will come way down over the next 12 months. My guess is that junk bonds may be the best-performing asset class of 2003.

Q: Any opinion on munis for the bond investors among us?

A: This may be a year when you'd be better off paying the higher taxes and staying away from munis. State and local governments are feeling the pinch much worse than the federal government is, so, many states and other muni issuers will probably have some real credit-quality issues over the next year.

Q: Is there a trend most investors are not seeing right now?

A: Many investors are still looking to the technology sector for recovery and growth.... That's where they made so much money in the '90s, and that's where they've lost so much money in the last few years. But they are ignoring that the rest of the economy is recovering well already. If you take out the technology and telecom sectors from the S&P 500, the rest of the S&P 500 has already recovered back to within 3% of all-time peak earnings.

Q: Don, what do you make of Bush's new economic team?

A: Well, I hope you'll forgive me if I seem unpatriotic, but of all the people alive on earth today that Bush could have picked as replacements, I can't picture less inspiring choices than John Snow and Stephen Friedman. Both of these men are old-fashioned deficit hawks who do not understand the dynamics of rapid economic growth. They come from a tradition of lobbying, of regulation, and of austerity.

I can't think of a less effective way to stimulate the economy than to cut taxes on dividends paid by old-line industrial companies like CSX (CSX), the railroad company that our new Treasury Secretary came from.

Q: Don, what advice would you leave investors with as we head into the New Year?

A: Keep your day job. Gone are the days when investing was about easy money. You can make money at this, but it involves risk and hard work. And don't forget that many intelligent people have devoted their lives and careers to it. So be very careful. Risk is not as heavily rewarded as brains.

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