10 Questions Roundup: Where's the Market Heading, and What Looks Good?

Let's face it, the stock market is looking about as safe and clean as Times Square in the 1970s.

Last week the Federal Open Market Committee shocked investors by slashing the key fed funds rate by 50 basis points earlier than anticipated. Despite the market's gaga one-day rally on the news, things look ominous from nearly every angle as some fear that we're riding right into Recessionville.

Yes, the tech-laden Nasdaq Composite Index is down more than 50% from its March 10, 2000, peak, but tech spending and tech stocks' earnings are still sagging. That makes today's valuations still look rich. But traditional defensive sectors like financials, utilities and energy stocks are coming off a hot year and don't look that cheap, either.

So, instead of chatting with one manager, this week's 10 Questions asks six pros what kind of market we're in and where they see the most glaring risks and opportunities. We also ask them to name one or few stocks they'd buy today and hold for the next two years. These folks don't see any way around a painful first half of 2001, but a potential rally in the second half -- maybe. Most think retailers might be the only port in this year's storm, but some see tech and telecom stocks as solid longer-term picks. That said, these folks aren't a chorus. They've got differing thoughts on everything from the economy to AT&T's(T Quote) growth prospects.

Our eclectic panel includes 10 Questions vets like unflappable value manager Bill Nygren, straight-talking tech specialist Paul Meeks and unheralded growth guru Jeff Van Harte. Here's a scorecard, including their two-year stock picks; scroll down to read what they have to say.

Expert Panel Here's a look at the pros we queried about the market, and their picks for the best stocks for the next two years.
Expert	Pick(s)	P/E Multiple*	3-Year Return
Jeff Van Harte ((TEQUX Quote)Transamerica Premier Equity)	First Data	22.9	24.3%
	CVS	25.6	19.3
Pat Dorsey (Dir. Stock Analysis, Morningstar)	Dell	18.1	21.8
Bill Nygren ((OAKMX Quote)Oakmark(OAKLX Quote)Oakmark Select)	AT&T	25.3	-19.4
Paul Meeks ((MAGTX Quote)Merrill Lynch Global Technology)	Cisco Systems	43.9	58.6
Derek Felsky ((STEKX Quote)Strong Technology 100)	Veritas Software	103.8	129.8
	Radio Shack	23.3	45.3
David Kovacs (Dir. Quantitative Research, Turner Investment Partners)	Home Depot	37.2	38.0
	Wal-Mart	34.9	41.6
	WorldCom	N/A	-2.3
	Allegiance Telecom	N/A	N/A
Source: BulldogResearch.com and Morningstar. *P/E over the next four quarters' estimated earnings.

What kind of a market do you think we'll be in and what stocks/sectors present the biggest opportunities and risks?

Bill Nygren, Harris Associates (Oakmark Funds)

My best guess is that this year's market will be a continuation of the market we've seen since March, where investors are more focused on risk than return. It will be a market where prices continue to move toward fair prices. We see this as a negative environment for technology companies and positive for more traditional companies like financials, consumer products companies, industrial companies and retailers.

You can buy most companies in these [industry] segments at either a high single-digit multiple or low-teens multiple on next year's earnings in a market where the S&P 500 is still trading at 20 times next year's earnings. In that environment, I think the multiples are just too high in the tech sector.

Where I disagree with reaction to the rate cut is the sharp run-up tech stocks had. I think the bigger problem [for tech stocks] isn't demand for their products but their stocks' valuations. My long-shot prediction of the year: The Nasdaq could break 1000. I think the fund flow data from TrimTabs.com about large redemptions this week says that if the growth and momentum funds go through the redemptions phase value managers went through in 1999, there's a lot of downside for the Nasdaq. I also don't think there'll be as much corporate activity and buy-backs as you saw on the value side to soak up this selling demand.

Almost every call I get from the financial media is, "Geez, the Nasdaq is down so much, there must be values," but that's not how we see it.

Two-Year Pick:

One of the stocks I like best for the next two years is AT&T. I think there was a tremendous amount of pressure on AT&T at year-end because individuals were selling for tax purposes and fund managers were selling to pretend they didn't own the stock. [Selling a sagging stock at year-end can keep it from appearing on annual reports to shareholders.]

I think part of it is that they had two investors: folks looking for a dividend and stability, and others who came in looking for a growth play. Neither appreciated the other side. The growth investors didn't appreciate the stability and yield, while the traditional phone investors didn't appreciate the growth prospects. Any analysis I've seen of what the stock is worth comes out at substantially more than $20. [The stock closed on Friday at $20.19.] So it just looks very cheap. I also like the fact that there have been large insider stock purchases.

Pat Dorsey, Morningstar

I certainly hope it's going to be a year where fundamentals matter. Broadly speaking, we're still seeing a lot of negativity toward the Internet [stocks]. I think we're clearly not going back into the 1999 froth again. I think this is a GARP [growth at a reasonable price] scenario, so you might see more money go into the telecom carriers, where you get growth for a lower price.

Historically, retailers and financials have been two of the biggest beneficiaries of rate cuts once [the cuts] actually filter into the economy. A lot of retailers are looking cheap right now. A company like [discount mega-store chain] Costco Wholesale(COST Quote) is intriguing when rates are falling and the economy is slowing. That's a good environment for discount retailers.

In financials, I like [leading online broker] Charles Schwab(SCH Quote) right here. Look at what they just did to control costs. [Schwab announced plans to cut executive pay and offer unpaid leave to employees in the first months of 2001.] Those are the types of people you want to run your company. They're being proactive, they're saying this is what we're going to do to avoid a messy warning later. If you're a shareholder you've got to be happy with that.

I think the tech sector is going to have a rougher road until the second half of the year when corporate tech budgets loosen up. A rate cut will help eventually, but not in a day. Anecdotally, what we're hearing from [corporate information technology] managers is that they're spending less, but they're still spending on some things like data storage. That's good for companies like EMC(EMC Quote), Veritas Software(VRTS Quote), Network Appliance(NTAP Quote) and Brocade Communications(BRCD Quote). The only one of those that's attractive from a risk/reward standpoint is EMC.

A safer place to be not just this year but over the next couple of years are PC stocks. Dell(DELL Quote) and Compaq Computer (CPQ Quote) are really beaten up and may have bottomed.

Another area that's interesting are telecom carriers. WorldCom(WCOM Quote) is the cheapest of the group, and of course I wouldn't want to touch AT&T. The flip side is companies like Level 3 Communications (LVLT Quote)and Global Crossing (GX Quote) that are also cheap and growing faster than WorldCom.

Two-Year Pick:

I think I'd have to say Dell. You're buying a very high-quality company for a very low price with a proved management team. It has one of the highest returns on capital in the market and they're growing the business, moving away from PCs to servers and notebooks. At some level this is a bet on management, but it's one stock I think you could own for a couple of years and do pretty well without much downside.

Jeff Van Harte, Transamerica Funds

My best guess is that we're looking at a Dr. Jekyll and Mr. Hyde market. For the most part, the first half is just going to be scary. In the first half, people will be trying to figure out what's wrong. The risks right now are high valuations in certain tech sectors -- like optical networkers, servers and storage. A lot [of these stocks] have been cut in half, but they haven't disappointed with their earnings yet. I think nobody who owns any tech right now will tell you that it's OK. There are also some risks in stocks that were up a lot last year like utilities and energy. For example, there's a good chance utilities prices could bust this year and deflate earnings expectations in that sector.

I think the Fed easing rates will ultimately calm the markets when we get into the second or third quarter. At that point, people will know the market's bad but at least they'll know how bad it is and there will still be technological innovation. Right now the market is struggling with how bad the earnings will be and how sick the economy is, but once we know that, I think the market can look up.

Two-Year Picks:

I think [transaction processing shop] First Data (FDC Quote) might be a good idea. A lot of their profits come from their Western Union business and the company continues to do really well. The company will tell you there is some slowdown, but the cannibalization of cash transactions [by credit card transactions] gives them some stability.

Another I'd like is [drugstore chain] CVS(CVS Quote). They're growing faster than Walgreen's(WAG Quote) due to a strong store relocation program. Everybody talks about all these exciting new drugs and instead of owning Merck (MRK Quote) or Pfizer(PFE Quote), CVS gets a piece of all of them. A third one would be Safeway(SWY Quote), because they've really got a handle on their costs.

All of these are reasonably valued stocks.

Paul Meeks, Merrill Lynch

I'm operating under the assumption that even if we have a recession, which I think is a minority shot, we'll have a reacceleration of things in the second half thanks to the Fed and maybe a tax cut. With that in mind, particularly where I invest in tech, I think things will go well and maybe even earlier if the rate and tax cuts are deep enough. I think the Nasdaq will finish clearly in the black, but it might be in the red on June 30.

That's the premise for what we've done. Even if we do have a recession, I think we'll come back a bit in the second quarter we haven't gotten rid of our high beta holdings [those with the highest valuations and volatility], but we've let our cash mount up a bit. Right now we're sitting on mid-20% cash. [Friday,] I put some to work.

I think the leadership in tech has shifted from old era leaders to new era leaders. Some of these newer companies like Applied Micro Circuits (AMCC Quote)and Ariba(ARBA Quote) are actually doing well. I have enough risk in the portfolio, so [on Friday] at $32 a share, we bought some Nortel Networks (NT Quote)because we thought it was worth the risk on valuation. We did trim some of our riskier stuff, but now we're starting to chip away at cheaper stocks in those same industries. We're going to go through the first half with a barbellgreat stock, great story, high risk, with a value story too.

I think investors have to lower their risk profiles, but hold stocks from both the growth and value camps.

Two-Year Pick:

I'll go with [networker] Cisco Systems (CSCO Quote)for two years. I think they're one of the few old era tech companies that's done enough of the right things to repeat its success in the new era. I don't know if Microsoft(MSFT Quote) or Intel(INTC Quote) will ever be the stocks they were, but Cisco could do well. Also, the stock has been whacked so I don't think it has much downside risk. The strong do often get stronger in technology and these leaders often come out of tough periods better than weaker competitors who lose a lot of market share.

David Kovacs, Turner Investment Partners

This is a market that's basically realizing that we're in a profit recession, especially in the tech sector. I personally have no doubt that we're already in a recession. The question is how long will it be and how bad will it be.

Right now I think the two major risks are high valuations but falling earnings in the technology and biotechnology sectors, and the risk of major defaults in the financial system.

The highest risk is to the highest multiple stocks, technology stocks like EMC, BEA Systems(BEAS Quote) and Siebel Systems(SEBL Quote). These are great companies with great products and competitive advantages, but they have very high multiples. If these companies miss their earnings forecasts and guide earnings growth lower in the next four to six quarters, there's a tremendous risk there.

Biotech might be even riskier. A lot of the quality tech stocks have earnings and good earnings visibility. With many biotech companies you don't have that. You have the promise of profits down the road if their products are approved and then marketed well. Then they also need additional drugs in the pipeline. It's wonderful that we've been able to map the human genome but there's a lot of risk there too.

There's also a lot default risk for money center banks. We've got a tug of war between falling rates, which is a positive for banks, and the risk that major corporations will default on loans. The market is looking for a bombshell. Who could default? There's no way to know. The market hints that there's a problem with the credit markets. If a major bank like Bank of America(BCA Quote) or Morgan Stanley Dean Witter(MWD Quote) says we have a lot of bad loans on the books and we need the U.S. government's help, that could be a huge bombshell. The fact that the Fed has cut [rates] by 50 basis points ahead of schedule, it's more of a warning signal than a positive act. If a doctor prescribes huge amounts of medication, it means they're really, really sick. The Fed must have seen something.

At this point to me it's too early to say it's a bust or boom year. I'm very cautious, I'm very nervous.

Remember there's also a huge reversal of the wealth effect. People have lost thousands and millions of dollars. The first thing those people do now is they stop spending. They buy less at the grocery store. They try to save on clothes, food, cars, vacations and home additions. And people are the engine of the economy. Nobody can factor this in correctly because nobody knows how bad it will get because there's never been a run-up like we've seen in the past few years.

Two-Year Picks:

The two areas that look attractive are retailers and specialty communications companies.

In retailers, I like Home Depot (HD Quote)and Wal-Mart(WMT Quote). I'm picking these assuming the economy recovers by the end of the year. In specialty communications one stock I'm a little tempted on is WorldCom; it has been beaten up, has solid cash flow and has now digested MCI. They can now focus on the high margin business. Another more speculative bet is Allegiance Telecom (ALGX Quote). They provide regular phone service as well as broadband in metropolitan areas. They've been beaten down but may be able to survive and actually do well if the economy gets better.

Other defensive areas like HMOs, hospitals and food companies aren't looking too good to me because they aren't as cheap anymore. The opportunity there was in March. The party may be over for utilities, too.

Derek Felske

I think we're going to be in a trading range through the fall because the sectors that have performed, health care and financials, aren't cheap anymore. We use target prices with stocks we own, and right now all of our defensive stuff like pharmaceuticals and financials are in the yellow zone -- meaning they're above our target price. We try to say this looks expensive, but we wait until we have a better alternative before we sell. We're also trying to be tax-efficient.

And tech stocks are back to where they were in 1998 and, in some cases, 1997. But they need a catalyst. The Fed's move is a positive, but historically when rates are cut it's because the economy is slowing and tech trades on rising demand and earnings and [because it takes time for rate cuts to spur growth] we're not going to see that until the third quarter. I think right now the market is as bifurcated as it was in 1999. Then it was buy tech and sell everything else and now it's the opposite.

The second half could be pretty cool. I tell fund investors they should dollar-cost average with our aggressive funds, so they buy more when the market is down than when it's up.

Two-Year Picks:

It's a tough call. I think the retailers are the best to own for the next six to nine months. But I think Veritas Software is a name I feel comfortable with for two years. Data storage spending is still growing. When you hear about slowing spending on tech, this is one of the few parts that's actually still growing. Right now though, you've just got to buy it [on the way] down and that's what I've been doing.

In the retail area I also like Radio Shack (RSH Quote) because of what they're doing with putting DSL [digital subscriber line service or Internet access] in the home. That's just starting to ramp. With BestBuy(BBY Quote) and Circuit City (CC Quote) already way down, I think it's interesting that Radio Shack has been able to hold up.