Lessons From the Bear's Bite

With the Dow and the S&P 500 up 20% from September's low and the Nasdaq up 40%, investors might be tempted to forget the lousy investment returns of the past year and just search for next year's winners. But as I described in June in "Trading Rules to Live By," it's important to make notes about what went wrong during this bear market in hopes of recognizing similar situations in the future.

Classic Bear Markets

The prior year, in June 2000, I described in "A Brief History of Bear Markets" the classic causes of bear markets:

Federal Reserve actions (raising the fed funds rate, reducing money supply growth)

A loss of market liquidity

The outbreak of war

During the past two years, we've seen all three factors in play -- the Fed raised rates through 2000, peaking at 6.5% in November that year; there was a collapse of liquidity as cash flowed out of mutual funds for most of 2001 and investors were forced to sell stock to meet margin calls; and, bolt out of the blue, there were the attacks on the World Trade Center and Pentagon, and subsequent war against terrorism.

While I was pessimistic about the outlook for stocks in June 2000, I in no way anticipated how long or how vicious the resulting bear market actually would be. We managed to deliver positive returns to our clients in 2000, but short of a miracle rally between now and year-end, we'll be down 8% to 12% in 2001.

Related Stories

The Mostly Efficient Market Hypothesis, Part 2

The Mostly Efficient Market Hypothesis

Picking the Best Sectors for the Coming Months, Part 2

Picking the Best Sectors for the Coming Months, Part 1

Rebalance Your 401(k) With This Annual Checkup

Flipping through the notes in my log book over the past year, I see that the biggest factor in prolonging this bear market was the collapse of business investment spending that started in the fourth quarter of 2000. In the U.S. economy through the 1930s, cycles of business overspending and underspending were responsible for numerous business crashes. From 1945 on, better management techniques and just-in-time inventories allowed businesses to smooth out revenues and earnings to the point that fluctuations in the business cycle had less impact on the economy than did changes in interest rates and monetary growth.

I assumed, therefore, that when the Fed began cutting rates in January 2001, economic growth would soon pick up, but it didn't. Why not?

Well, it certainly wasn't the consumer's fault. Consumers account for about two-thirds of consumption in the U.S. economy. The low unemployment rate, rising house prices, mortgage refinancing at lower rates and the prospects of tax cuts have allowed consumers to keep spending, despite lowered consumer confidence and a high consumer debt load.

But business investment, which represents about one-third of the economy, went off a cliff in the first half of 2001. Many corporations gorged on technology in 1999 to prepare for the Y2K conversion and to adapt business practices to the Internet economy. By 2001, however, there was no need to double up on, for example, Sun Microsystems' (SUNW - commentary - Cramer's Take) servers, and incremental purchases could be obtained from equipment sales on eBay (EBAY - commentary - Cramer's Take).

In late 2000, we anticipated that Sun's stock price could fall about 30% on flat revenue and lower earnings; instead, the stock price fell nearly 90% on a 43% revenue decline and negative earnings.

In addition, about $900 billion was raised to build fiber-optic networks, for which demand failed to materialize. As transmission rates fell 40% per year for three years running, provider after provider went into bankruptcy, dumping more capacity onto the market and depressing prices still further.

Flaky dot-coms, the source of high demand in 1999 for equipment, personnel and advertising spending, largely disappeared in 2001. And companies like Cisco (CSCO - commentary - Cramer's Take) and Lucent (LU - commentary - Cramer's Take) took a double hit -- not only were future revenues lost, but in many cases, equipment was sold with vendor financing that had to be written off against current earnings.

Why Low Rates Aren't Helping Now

Historically, the U.S. economy rallies six to nine months after the Fed first starts cutting rates. Aside from the additional uncertainty created by the war against terrorism, economic growth continues to be weak, with negative 0.5% growth for the third quarter of 2001 and a likely flat to negative result for the fourth quarter. Even with short-term interest rates at their lowest level since 1962 and inflation at virtually 0 percent, businesses have no compelling reason to invest because capacity utilization being at its lowest levels since the last recession in 1992.

Look Out When Business Investment Picks Up

In an October column, "Picking the Best Sectors for the Coming Months," I wrote that "technology stocks, which most investors seem to hate right now, are particularly interesting to me. The most profits can be made when the tide turns in earnings growth, and there are several reasons why I think the tide might be turning now."

Despite the wipeout of the pure-play Internet companies, the Internet as a marketing and distribution channel is here to stay. Much of the infrastructure installed in 1999-2000 will be obsolete by 2003, which means an upswing in demand for technology in 2002 and an upswing in demand for equipment to build technology should be starting about now.

Companies in that industry group, including Applied Materials (AMAT - commentary - Cramer's Take), Lam Research (LRCX - commentary - Cramer's Take) and Sanmina (SANM - commentary - Cramer's Take), are up 30% to 45% on the quarter, and I believe they have a long way to go.

Despite gloomy prospects for the technology sector through the first quarter of 2002, technology stocks have been on fire this quarter with 50%-plus gains for Broadcom (BRCM - commentary - Cramer's Take), Nokia (NOK - commentary - Cramer's Take), PeopleSoft (PSFT - commentary - Cramer's Take), Sun and Yahoo! (YHOO - commentary - Cramer's Take). As I said in October, "established technology companies with products shipping now, good cash flow and cash in the bank are at the most attractive valuations in five years."

Classic Bear Markets Updated

So now I've updated my list of rules to include "Collapse of Business Investment" as a future trigger of bear markets. I'm reasonably confident that this bear market is over, and I'm looking forward to positive returns for my clients in 2002. That's because the war against terrorism is going better than anyone had reason to hope, and I'm alert for setbacks (more anthrax outbreaks, major casualties among U.S. soldiers, etc.).

I don't expect substantial cuts in fed funds rates going forward -- after all, there's not much room between 2.5% and 0% -- but flat to negative rates of inflation (as seen in the major commodity indices, the producer price index, consumer price index and gross domestic product deflator) tell me that the economy can grow for a while before fed funds rates are increased.

The most bullish development would be a sharp increase in S&P 500 earnings. According to Ed Yardeni's Fed model, (which values the S&P 500 as a function of next year's expected earnings and the current yield on the 10-year treasury), the S&P 500 is overvalued by 9%, with a forecast of earnings declining 3.5% over the next 12 months, and the 10-year Treasury yield at 4.92%. The market, however, is fairly valued if earnings grow 5% over the next year, or if yields decline back to 4.5%.

---

David Edwards is a portfolio manager and president of Heron Capital Management, Inc. , a New York investment management firm. At time of publication, Edwards held long positions in Yahoo!, Sun Microsystems, PeopleSoft, Nokia, Broadcom, eBay and Cisco, although positions can change at any time. Edwards appreciates your feedback at [e-mail].