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Nasdaq 2000: Old Friend, New Math

While tech stocks are expensive, analysts note some key differences between now and then.

Editor's Note: This is an updated version of a story that originally ran Nov. 7.

When you've seen

Nasdaq

5000, Nasdaq 2000 doesn't seem so impressive.

Perhaps that's why analysts are greeting the milestone with a giant yawn. Still, it's been more than 20 months since the tech-heavy index was sitting at this level, and more than five years since it crossed 2000 for the first time. For some investors, the barrier is at least psychologically important.

"It's certainly encouraging to people," said Ed Peters, chief investment strategist at PanAgora Asset Management. "It's a sign things are getting better."

When the Nasdaq first crossed 2000 in July 1998, it presaged a tremendous run that would take the index to 5000 within just 20 months. Y2K upgrades, a big increase in Internet usage, ample liquidity from the

Federal Reserve

, massive venture capital availability and wild speculation in technology stocks such as

Cisco

(CSCO) - Get Cisco Systems, Inc. Report

,

JDS Uniphase

(JDSU)

,

Yahoo!

TheStreet Recommends

(YHOO)

,

Amazon.com

(AMZN) - Get Amazon.com, Inc. Report

and

Research In Motion

(RIMM)

all helped to catapult the Nasdaq to new heights.

Of course, the good times didn't last. By March 2001, the Nasdaq had fallen back below 2000 and by October 2002, it had dropped to 1108, the lowest level in six years.

Given these wild gyrations, it's not surprising that investors are skeptical about Nasdaq 2000 this time round. Yet there are reasons to think this latest move could be meaningful.

For one thing, valuations are lower today than they were when the Nasdaq first broke through 2000, or when it was last there in January 2002.

In 1998, the price-to-sales ratio of the Nasdaq fluctuated between 5.9 and 9.7, according to Baseline. Things got even more ridiculous in 1999 and 2000, as the index zoomed into the stratosphere. But this year, the Nasdaq's price-to-sales ratio has moved in a range of 3.17 and 4.85. By any measure, that's still an extremely high valuation, but it's certainly more reasonable than it was before.

Consumer confidence is also lower today than it was in either July 1998 or January 2002, and short interest on the Nasdaq recently hit a record high, which is considered positive from a contrarian point of view.

Another favorable development is the drop in interest rates. When the Nasdaq first crossed the 2000 mark, the yield on the 10-year note was sitting at 5.5%, and in January 2002 it was at 5%. Today, thanks to further cuts in the fed funds target rate, the note is yielding just 4.4%.

Lower yields in the bond market make stocks more attractive to investors. They also encourage businesses and consumers to borrow more money, and that leads to greater spending. In the third quarter, consumer spending jumped at a 6.4% rate, according to the Commerce Department, and business investment rose by 18%.

Still, there are a couple of flies in the ointment. Despite a big leap in economic growth recently, the unemployment rate is sitting at 6%. That's up from 5.6% in January 2002 and well above the 4.5% rate in July 1998.

Although recent data have pointed to an improvement in the labor market, analysts say it could still take several months before job creation is sufficient to offset the growth in population, and that could put pressure on consumer spending.

"Normally, at this point in the cycle after a recession there should be about 3.5 million new jobs, and instead we're down well over a million, so that's very disturbing," said Jim Melcher, president and market strategist at Balestra Capital.

Also worrying is a massive budget deficit in the U.S., caused by the government's trillion-dollar tax cuts. The trade gap, which is the difference between imported and exported goods, is also extremely wide by historic standards. Analysts fear that these deficits will cause the dollar to weaken, prompting foreigners to take money out of U.S. stocks and bonds and ultimately sending interest rates higher.

"There's been a deterioration in the U.S. financial position that's enormous," Melcher said. "We've gone from a federal budget surplus to a budget deficit, we've got a massive trade deficit and massive job loss."

Melcher doesn't regard the 2000 level as significant, noting that the Nasdaq is still down more than 60% from its high. Although some things may have changed for the better, he believes the economy is now facing a new set of problems.

"You're seeing no pricing power and only modest revenue growth," he said. "This wasn't a recession that cleared out dead wood. In past recessions, a lot of companies went out of business. In this one, all too few went under."

While the accounting scandals and subsequent reform in 2002 helped clean up corporate balance sheets, the use of pro forma accounting is still prevalent, and investors continue to give higher premiums to companies with no earnings and no dividends.

Still, John Hughes, market strategist at Shields & Co., said that breaching the 2000 mark is psychologically important for investors, and he is more optimistic that the Nasdaq can hold above this level going forward.

"Is it different this time? In some sense yes and in some sense no," he said. "Valuations are still very high, and you could argue this is the second-most expensive stocks have been. But we're in a different environment here. We've just come off a huge decline, and the fact that you're moving back up through that 2000 area is a sign of some resiliency and strength."