Happy New Year: Proceed With Caution

Had he been able to do it all over again, Stanley Kubrick might have titled his masterpiece, "2001: The Year the Market Figures Out What the Heck is Going On."

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Since March, the major stock indices have been smacked mercilessly around the head and neck. The Dow is down, the Nasdaq is way down, and IPOs have all but dried up. At least one major company warns every day; dot-com darlings have seen their stocks head lower and lower, or have closed down entirely; and, to top it all off, the economy is finally showing signs of weakness.

Happy freakin' New Year.

Despite this year of woe, it's taken until the last couple of months for investors to start acting even a little chastened. Even through September, many market observers were convinced that technology stocks, horribly battered, would come roaring back strong. Investors continued to try to play the momentum game and buy the dips in big-cap technology stocks at a time when mid-caps and utilities were the ones kicking butt.

So, despite what has turned out to be a pretty lousy 2000, many market observers say they see some hopeful signs for the stock market in the coming year.

Next year, in terms of investing style, portfolio managers and strategists believe a little more humility will be in order, especially if the economy is displaying signs of several quarters of growth below what the market's become accustomed to (which is about 4% per year). Expectations have changed -- people are starting to see risk in stocks again.

Charlie Crane, market strategist at Spears, Benzak, Salomon & Farrell, attributes some of 2000's volatility to the gap between investor expectations and reality, both in terms of the market's broader performance and company performances. He thinks that during 2001 -- primarily because the anticipation is for a slower, less exuberant year -- volatility will diminish.

"You've had this year a relatively volatile economic environment that was extremely hot earlier in the year and has considerably cooled since," he says. "If we attenuate that in 2001, and the hottest period isn't as hot as this year and the cool isn't as cool, the volatility won't be as high."

However, strategists say, don't expect investors to tuck their tails between their legs. Buying stocks and holding onto them, or adding to those positions, has largely been a winning strategy for five straight years. A couple of months of poor performance aren't going to shoo investors away so easily.

"Investors are never going to change: They're going to look for that momentum," says Barry Hyman, chief investment strategist at Weatherly Securities. "Investors will still seek out the gains that can get them the home runs, rather than understand this is a market that represents a different scenario given the valuations, which are still slightly overvalued, and given earnings concerns."

Let's Be Careful Out There

But Hyman and others expect more caution and a reduction in some of the frenzied bingeing and purging of stocks seen during 2000. Slowing economic growth may also steer investors to a bit more prudent behavior. That started to emerge in the latter part of this year. Share turnover on the New York Stock Exchange, which reached a record 109% rate in March, slowed to an annualized 86% rate in November. This indicates a mild decline in performance-chasing.

Margin debt, where investors borrow money to buy stock with the promise of repaying it later, is down from a record $278 billion in March to $233 billion in October. Block trading volume on the Nasdaq, a measure of more buying by institutions (larger sales at one price cause less volatility) accounted for nearly 28% of all volume in October, higher than in 1999, when it averaged 24.6%.

What investors do instead is move toward further diversification. That's with regard to stock sectors, as well as outside the stock market. David Sowerby, portfolio manager at Loomis Sayles in Detroit, says that in 1997, when the S&P 500 finished the year up 31%, both value and growth stocks had a strong year.

The extreme polarization of 1999 was bound to be corrected -- as it was in 2000. Now, the broader performance of various sectors should be a bit more closely aligned, Sowerby believes. A chart of the Nasdaq Composite Index and the S&P 500 shows just how disconnected the Nasdaq became in early 1999. It still hasn't quite returned to that, but it may continue to correct if the economy slows.

Only Disconnect

Sowerby also thinks investors should -- gasp -- buy a bond or two. The Merrill Lynch Master Treasury Index has returned 11.262% through Nov. 30 this year; there aren't many domestic stock indices anywhere near that.

What's most likely next year, if the stock market is to do well at all, is for a modest rally similar to the pre-explosion days, where stock investments returned, on average, around 10%. Of course, the market could surprise. If the Fed sharply reduces interest rates next year and the economy reacts positively, that could be a catalyst for a strong market rally.

But nobody's really expecting the latter, and that may preserve some sanity next year.