Is The Party Over?
It was the most volatile day in the history of the stock market. Both the Dow Jones industrial average and the Nasdaq plummeted more than 500 points before staging a remarkable recovery. Thousands of margin calls went out around the country. Accounts were closed out. Novice investors who had made thousands in a few months saw their bounty wiped out in the course of a few hours. Even seasoned investors, who were coming to believe that Wall Street had signs pointing in one direction--up--were shaken. Is this just the beginning of a major market shakeout? Is the party over?
No. Apr. 4 was a day that crystallized the change in leadership of the bull market that began three weeks earlier. It is not so much a change from New Economy stocks to Old Economy stocks; rather, it is a flight to quality across the entire equity spectrum.
Just look at the numbers. Since Mar. 10, the day the tech-heavy Nasdaq peaked, through Apr. 5, that index has fallen 17.8%. Even more jarring, the Dow Jones Internet index has plunged 34% during the same period. Still, tech leaders like Cisco Systems, Dell Computer, and Intel have continued to rise. Also, the blue-chip Dow has risen 11.1% with stocks like Eastman Kodak, Procter & Gamble, and Citigroup posting solid gains.
Call it convergence. It can only be healthy for the market. For the last year and a half, the stock market has become a market of extremes: extremely high valuations for the New Economy denizens that dominate the Nasdaq--and extremely low valuations for anything that smacked of the Old Economy.
In the past few weeks, and especially the last few days, the market tried to correct those extremes. True to form, the shift took place in an extremely violent way. First, the Nasdaq Composite, which gained an amazing 130% from the beginning of 1999 up to Mar. 10, slid 16% in three weeks, a swift and severe correction by itself. Then, on Apr. 4, the tech-dominated index fell off the cliff.
What's really going on here is a massive shift in investor psychology and a dramatic reevaluation of companies with lots of nifty ideas and great potential but not much else. Old Economy giants are winning new respect from investors, while New Economy darlings like Juniper Networks Inc. and Veritas Software are losing some of their luster. Investors didn't abandon tech stocks altogether, but they definitely switched from companies on the come to companies that have arrived. Bluer-chip tech stocks--companies with real products, revenues, and profits--displayed strength in the face of the sell-off, and indeed are higher now than they were on Mar. 10.
This shift, though painful for many investors, especially those who had bought tech stocks on margin, should ultimately turn out to be beneficial for the stock market as a whole. For one thing, many institutional investors have been on the sidelines, waiting for signs of life in quality value stocks. That means more money, rather than less, could be flowing into the market.
The correction in high-priced high tech will also dramatically reshape the initial public offering market--and for the better. Many startups will never make it to market, and many already-public Internet companies will find it harder to get further financing. Metropolitan Life Insurance Co. and Krispy Kreme Doughnut Corp., the donut chain, successfully launched IPOs in the midst of the rout. Neither company was competing for dot-com dollars.
"Momentum had taken the Nasdaq to levels it shouldn't have gotten to in the first place," says Joseph Battipaglia, market strategist for Gruntal & Co. Of course, last year at this time, the market was also shifting--though less dramatically--from tech to industrials. But six weeks later the market sentiment turned back to New Economy stocks. Battipaglia says this year is different, with Old Economy stocks better poised for performance. "We've already had five rate hikes, whereas last year we were just entering into a period of higher rates," he says. "We've had the recovery of Asia, and a recovery in oil prices."
The partial deflation in stock prices could slow the economy a bit, something Fed Chairman Alan Greenspan has yet to do through five interest-rate hikes over the past nine months. In remarks at a White House conference on the New Economy, Greenspan signaled that rates were likely to go higher gradually. He shrugged off the market volatility and remained bullish on the economy: "I see no reason that productivity growth cannot remain elevated, or even increase further, to the undeniable benefit of businesses and workers."
BEST FOOT FORWARD. Indeed, the economy remains robust. The most recent figures show that consumer spending, manufacturing, production, and productivity are strong. Inflation is still modest and energy prices, which were getting scary a few weeks ago, have moderated.
Perhaps the most important factor that will help market stability as well as investor confidence is strong corporate profits. The first-quarter earnings reports will start coming in within days, and the outlook is excellent. According to I/B/E/S, the earnings research firm, it will be another record-breaking quarter for profits. That includes the tech sector, which is projected to grow nearly 35% over the first quarter last year. And analysts have raised their Year 2000 earnings estimate for companies in the Standard & Poor's 500-stock index to 17.9% from 17.2%, according to First Call Corp., another earnings research firm.
The bulls, of course, are trying to put their best arguments forward. "At times like this it's important to step back and look at the big picture. We have a healthy economy with rapidly growing earnings and no inflation problem. And globally we have a growing demand to own common stock," says Alfred Goldman, chief market strategist at A.G. Edwards & Sons Inc. in St. Louis.
"The bull market doesn't end here," said market strategist Abby Joseph Cohen of Goldman, Sachs & Co., speaking at the White House conference. "We think the economic and profit expansion will continue." Some market watchers credit--or blame--the influential Cohen for triggering the Nasdaq debacle. On Mar. 28, she advised Goldman clients to scale back their technology holdings and raise some cash. Of course, there were other factors that contributed to the Nasdaq's woes, like the collapse of the settlement negotiations in the Microsoft antitrust case. Microsoft is the largest stock in the capitalization-weighted Nasdaq. Also, a report that many Internet companies were running out of cash took its toll. So did stories of the market getting flooded with stocks by IPO executives who would finally be free to cash in.
Although record trading volume and volatility may cause investor jitters, it can be a bullish indicator. By some measures, Apr. 4 was the most volatile day ever in the stock market. Says Bernard Schaeffer, who heads an investment-research firm in Cincinnati: "This usually indicates a bottom and that the worst is behind us."
Or is it? Despite the move to quality, the market remains overvalued, say some analysts. Even with the improved earnings forecasts and lower bond yields, many valuation models still point to continued trouble. Douglas Cliggott, U.S. equity strategist at J.P. Morgan & Co., says by his reckoning, the S&P 500 is still 22% overvalued. "Our concern is that there's likely to be bad news on the horizon in terms of inflation and interest rates," he says. He recommends investors look at companies that have a global presence, like General Mills and PepsiCo, as well as drug companies Merck and Schering-Plough.
One thing Cliggott and even the more bullish analysts agree on is that some of the speculative players--those who use borrowed money to trade already risky issues--have been humbled, if not forced from the market.
Margin debt is at its highest level ever: It now represents 3% of personal income, three times the historic norm, according to a study by investment management firm Sanford C. Bernstein & Co. And the stocks investors are buying on margin have betas, or volatility, as well as price-earnings ratios, well above the market's average, the study shows.
"The good news is that the speculation has pulled back. And in the long run, that makes for a much safer, less volatile market," says Jeffrey M. Warantz, an equity strategist at Salomon Smith Barney.
TRENDING HIGHER? Moreover, the Dow and the Nasdaq are now on more equal footing, with the Dow down 3% for the year and the Nasdaq up 2%. "The main issue is the divergent market. Nasdaq had been going one way and Dow the other, but now they're starting to move the same way and trend higher," says Mark Leibovit, chief market strategist and market technician at VR Trader, a day-trading firm in Sedona, Ariz. He thinks that both the Dow and the Nasdaq will move substantially higher in the next 12 months.
The Nasdaq lows hit on Apr. 4 didn't deter some tech aficionados. Frank "Quint" Slattery, a big tech investor at PBHG Funds, sold his Microsoft, Cisco, and AOL to buy favorites that had been taken down 50% to 60% in the fall--InfoSpace.com, Broadcom, Brocade Communications Systems, and Exodus Communications among them. "It was the bargain of a lifetime for some of these stocks," Slattery said. Ken Wolff, who owns a day-trading firm in Paradise, Calif., says his firm's strategy was to grab beaten-down blue-chip tech stocks like Oracle, Cisco, and JDS Uniphase as they hit bottom during the day: "That was where all the selling was occurring, so we expected the buying to occur there too." They played it right. His traders' profits ranged from $27,000 to $300,000 in the course of the day. "It was a flight to quality in tech," he says, adding that his traders also played the Dow as a "buy and hold" strategy--grabbing stocks like Chase Manhattan, Procter & Gamble, and AT&T as they bottomed out. "We'll keep them for days, weeks or months, depending on the market's momentum," he says.
The fast-money crowd may need a break. Establishment players like Steve M. Milunovich, Merrill Lynch & Co.'s manager of technology research, say that the market will be less forgiving, particularly in the Internet sector, and that finally, cash-producing business models appear to matter to investors. "The place to be is infrastructure space where companies with real earnings will enjoy spending by the Internet companies," he says.
Also, there has been a flight to quality in biotechs, with investors turning to proven companies like Amgen, Chiron, and Genentech that have deep pipelines and successful products already on the market. The sector, which hit an all-time high on Mar. 7, has been sinking since mid-March due to a news announcement from President Clinton regarding free access to genome research. "Earlier this year, we were buying everything because we knew it would go up. This isn't true anymore," says Faraz Naqvi, manager of the Dresdner RCM Biotechnology Fund.
There's no guarantee that the move to quality alone will send the market to new highs. But at least it will be able to climb on more solid ground.