To begin with, if you think 2002 is going to be another year of red for stocks, you ought to take a look at the historical record.

Three consecutive years of decline is an incredible rarity in the U.S. stock market. Since 1896, the

Dow Jones Industrial Average

has seen such mean streaks only three times. The last time was 1939 through 1941, when the country was caught in the juncture of depression and the prospect of war. Things don't seem so bad as that just now.

Glancing up from the history book, it's also important to note how much cash got pumped into the economy in 2001. The Federal Open Market Committee cut the benchmark fed funds target rate 11 times, from 6.5% to 2% -- the lowest level in more than 40 years. Lawmakers have provided significant stimulus. Even the most dour economist reckons the recession will end this year. With that turn in the economy will come (with a slight lag) a turn in earnings.

All in all, it seems a decent environment for stocks.

Yet Wall Street is deeply divided on whether the market will perform well in 2002. Former Merrill Lynch strategist Chuck Clough liked to say that the most important fundamental of any security is its price, and in the current environment, there are some who feel the market's price is far too high.

Based on analysts' estimates for next year, the forward price-to-earnings ratio on the benchmark

S&P 500

is 25 -- the high end of its historical range. For contrast's sake, at the trough of the last recession the S&P's forward P/E was 14.

Moreover, some strategists think that analysts' earnings expectations are simply too high. Following the consensus among economists, they do not believe the recession will end until toward the end of the first quarter at the soonest. They also see companies caught between little pricing power and, thanks to low capacity utilization rates and still rising wages, high costs.

A weakening Europe and what is shaping up to be a truly horrific year in Japan (even by Japanese standards) will also take its toll. According to Morgan Stanley, 25% to 30% of S&P 500 company profits come from overseas.

Yet analysts expect second-quarter S&P 500 profits to be 8% above year-ago levels.

Ain't No Sunshine When She's Gone

"We think they'll be about 10% lower," says J.P. Morgan strategist Doug Cliggott. "If we're right, and that difference in expectations evaporates over the next few months, we'll see quite a bit of downward pressure on stocks.

"Right now, we're entering a very high-risk period," he continues. "The greatest period of vulnerability is probably six to eight weeks into the new year. I think we'll be getting a steady stream of businesses saying the first quarter is worse than the fourth was, and that the prospect of an upturn in the second isn't very great."

Some see in the market's expectations of a quick snapback in the economy and earnings a sort of circular logic.

"I'm still amazed at the extent to which the market is jumping ahead on this particular recovery," says Banc of America Securities equity portfolio strategist Tom McManus. "Stocks have gone up, therefore we're more confident about the economy. But none of the evidence independent of the market is leading you to believe anything is getting better."

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But of course not everyone is down on the stock market right now, and they, too, have there reasons. Chief among them is that people are always misjudging the strength of both markets and the economy coming out of downturn.

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"If a year and a half ago the average portfolio manager was too young to know what a bear market looks like, by definition the average portfolio manager today is too young to know what the end of a bear market looks like," says Salomon Smith Barney portfolio strategist John Manley. "This is the classic end of a recession and the classic end of a bear market."

Manley notes that earlier this year, downward estimate revisions by analysts were far outstripping upward revisions -- a situation reflective of a market in the process of realizing things are much worse than it thought. Now, however, upward and downward revisions are running neck and neck, suggesting the market's recent up leg is not for nothing.

Such a Relative Term
The S&P 500's forward P/E*

*Based on estimated earnings. Sources: Baseline, Thomson Financial/First Call

Even some former diehard bears have become constructive on the market. "We may not enter a bull market, but we're finished with the bear market," says Stanley Nabi, value-oriented managing director at Credit Suisse Asset Management.

Nabi is reckoning on further economic contraction in the first quarter, followed by a recovery that will take earnings higher. He is, however, maintaining a defensive profile on the expectation that the earnings of cyclical companies -- those whose profits wax and wane most with the economy -- won't grow very quickly in the initial stages of recovery.

Because consumer spending has held up well through the recession, there is little pent-up demand for new goods, he says. Meanwhile, given that businesses aren't running anywhere near capacity, they aren't going to be buying much spiffy new equipment. Tech, with its rich prices, seems particularly dangerous to Nabi.

Some investors, though positive on the market, worry that the recovery will be short-lived.

"It's hard to be bearish when the Fed is doing everything for the economy except dropping $100 bills out of airplanes," says Bill Sterling, chief investment officer at the New York-based investment management firm Trilogy Advisors. "But the market is going to be very sensitive to whether there's anything out there besides an inventory cycle."

In the initial stages of economic recovery, when demand begins to grow again, companies that have been aggressively cutting inventories through the downturn find they need to rebuild stock again. This, in itself, contributes to growth. What you want to see after that are things such as consumers going out and spending again, because unemployment is falling again, and companies buying new equipment, because their old equipment is getting run ragged. And you want to see them buying splashy magazine ads and commissioning gargantuan new pieces of sculpture for the front lobby because, hey, that's what you're supposed to do when times are flush. Those are the after-burners that send the economy into a longer growth trajectory.

If Sterling doesn't see those after-burners kicking in, he's going to start thinking about not owning as much stock.

Beta Testing

Beyond the debate on how stocks in general will do in 2002, there's also an argument over what kinds of stocks one should own. The market has lately favored cyclical areas, in expectation of the economy's recovery. The cautious favor companies that tend to grow earnings through thick and thin, such as health care, utilities and consumer staples.

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Yet Merrill Lynch U.S. strategist Rich Bernstein thinks that investors may have gone a little too far in throwing caution to the wind, even if the economy rebounds quickly. He notes that high-risk, high-return areas are trading much more richly these days than safer stocks -- and this is not the norm.

For example, the S&P Consumer Staples sector has grown earnings at an average of 8% a year over the last five years and has a forward P/E of 21. Yet the S&P Tech sector has grown earnings at 7% a year over the last five years and has a forward P/E of 59. And the Consumer Cyclical sector has grown earnings at 1% a year and has a forward P/E of 32.

"Usually we pay for safety and are compensated for taking risk," says Bernstein. "But that's not what's happening here." Either that or the tech and consumer cyclical analysts, usually such an optimistic lot, have grievously underestimated the coming recovery in the economy.

Which gets us back to square one.

"One thing I've learned is whenever you make a projection for a year out," says Salomon's Manley, "the only thing you know about that projection is it's wrong." The trick, he says, and the way you end up making money, is figuring out how wrong you've been and adjusting for it.