2002 Preview: A Long Year's Journey Into Night

To paraphrase the Old Bard: What seest Detox in the dark forward abysm of time?

Dark things in 2002, and plenty of them.

Though 2001 was a terrible year for the stock market, 2002 could be equally bad, if not worse. It's hard to think of a time in the postwar period when the prerequisites for a sustainable rally have been as scant.

As ever, the bulls are girding up for a great year. But their arguments lack more substance than ever. At a lunch in New York in December, Legg Mason's Bill Miller, who many see as the nation's best mutual fund manager, said one reason stocks would finish up in 2002 is that they'd been down in 2000 and would likely show a decline in 2001.

In other words, the market rarely has three down years in a row. The S&P 500 declined 10% in 2000 and, at Dec. 21, it was off 13% in 2001. But a postive return in 2002 is as likely as Kandahar becoming Asia's next big tourist destination.

Detox expects the S&P 500 to drop around 20% in 2002 to between 850 and 950. This column still believes that the Nasdaq is going to crash more than 40% to the 1000-1100 range.

How so? Take a look at what's needed just to keep stock prices at current levels: reasonable valuations, a healthy, balanced economy, a friendly Fed, a stable dollar and political stability. Only the last is likely. Gary Condit will take Pat Robertson's place at the Christian Coalition before the other things happen.

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This is the hardest case for the bulls to argue. The S&P 500 is trading at 23 times expected operating earnings in 2002. Analysts are expecting earnings growth of 13% next year. A P/E ratio of 23 is way above the postwar historical average of 15, and many times higher than the market multiple during past recessions.

That means one of two things. Maybe our fathers and mothers were stupid to pay 15 times earnings, and we're far smarter nowadays because we know earnings will always recover to justify valuations. Or, alternatively, our generation is the dumb one for consistently paying more than 20 times earnings when companies' profits seem to disappoint so often.

The fact is, looking at productivity rates, U.S. corporations aren't as good now as they were in the 1950s or 1960s. That means fundamentals can't explain the difference. Money and psychology play a decisive role.

One big reason for stocks holding on to high P/Es is that money flows into stock market are far heavier than they were in the past. Over the past 20 years, the use of stocks as a source of retirement wealth and as savings has proliferated. People simply believe they have to be in equities over cash or bonds. That means the market professionals paid to manage these flows will find all manner of reasons to justify valuations that look absurd by historical standards.

But when earnings brutally disappointed in 2000 and 2001, that task became a lot harder. Because the bottom isn't falling out of the economy, profits won't be a complete disaster in 2002, but the market is already expecting a massive rebound, so there will be disappointment, probably in the second half. It wouldn't be too much of a surprise if S&P earnings came in around $50. But the growth outlook for 2003 will be poor. As a result, the multiple on the S&P will fall to 17-18 times, putting the index at around 875, or 23% below current levels.

The Fed and the Economy

Another huge difference between now and the '50s and '60s is that the Fed is far more accommodating in its monetary policy. But that will have to stop in 2002, hurting stocks.

Greenspan has shown no restraint in underwriting one of the largest increases in money ever seen, allowing M3, a measure of money supply, to grow $984 billion, or 14%, in the 12 months through November. That dollar increase is almost the same size as Italy's GDP.

Greenspan was prepared to make the interest rate cuts that created that splurge because inflation looks benign. But it's dangerous to fixate on a low inflation rate. Measuring the health of an economy by looking only at a narrow set of price increases is like a doctor checking only for a fever to determine someone's health.

Much can go wrong in a low-inflation environment, as can be seen by the massive overinvestment in technology and new-era power plants that took place in the latter part of the '90s. In fact, artificially low interest rates caused this type of wasteful investment. Until those excesses are undone, an economy can't recover evenly. But the fact that merchant energy companies were able to raise more than $2 billion at the end of December at the drop of a hat shows that there's still too much liquidity in the system and interest rates are too low.

And inflation will recur in 2002, forcing the Fed to retrench. The huge money creation hasn't led to an acceleration of inflation because it's not circulating through the economy at a sufficient rate. Much is "parked" on the sidelines. But in 2002 it will be put to work, boosting prices. As a result, the Fed will increase interest rates by the third quarter of 2002. Detox expects the fed funds rate to be at least a percentage point higher than the current 1.75% by the end of 2002, and the 10-year Treasury will have a yield of 5.5% to 5.75%, up from the current 5.08%.

Rising rates will undermine two sectors that have been on fire due to cheap money: autos and the housing market. In fact, the automakers, GM as well as Ford, will be the horror stories of 2002, as will auto-loan maker Americredit, which lends to people with tainted credit histories. In the housing space, MGIC Investment, which insures mortgages, will have particularly weak earnings in 2002 as it increases reserves to cover losses. What about Fannie and Freddie? As with GE, these companies are accounting black boxes and, as such, it's almost impossible to tell when they're out of steam. But 2002 won't be easy for either of them.

The Dollar and Politics

As for the dollar, it'll drift lower in 2002, making inflation harder to control and pushing up rates. True, it's hard to argue that the eurozone countries and Japan will do much to make their currencies strong. It's simply that the U.S. has done more to make the dollar weaker, like opening the monetary floodgates.

Neither the bears nor the bulls have politics on their side. International and domestic developments will be a neutral for the market in 2002. The Democrats will slightly increase their one-vote majority in the Senate, but the Republicans will hold their slim majority in the House.

It's hard to see Bush taking any gambles on the home front that could backfire and damage his approval rating, which will fall only slightly in 2002. His administration won't launch a full-scale assault on Iraq, but it will increase efforts to topple Saddam Hussein. The Israeli-Palestinian conflict won't get any worse and it won't erupt into a regional conflagration. Depressingly, Britain will warm to the euro.

And Prince Charles will announce his engagement to Camilla Parker Bowles, which -- you read it here first -- will have little impact on the Footsie.