SAN FRANCISCO -- It was a very good week for those who believe the first few days of the year set the tone for January, and that January sets the tone for the year -- a view that has historical precedents. It was not such a good week for those who worry about equity market valuations.

After suffering on 2001's final day, investors returned from Tuesday's holiday with an renewed sense of optimism. The unemployment rate rose to 5.8% in December, its highest level since April 1995, the government reported Friday. But the pace of job losses subsided, and the week's tally of economic data encouraged hopefulness. The Institute for Supply Management (formerly the National Association for Purchasing Management) released stronger-than-expected surveys on the manufacturing sector Wednesday and on the service economy on Friday.

The economic news, in conjunction with technical factors such as the

January effect and investors' general eagerness to buy stocks at the start of the year, fueled gains for the major averages.

For the week, the

Dow Jones Industrial Average

rose 1.2% while the

S&P 500

gained 1% and the

Nasdaq Composite

climbed 3.6%.

The trend in prices aside, the best part about this week for optimists was that the averages were paced by bull market sectors, notably technology, cyclicals, basic materials and industrials.

"If you're going to bet on a bull market, those are the sectors you're going to buy," said Hugh Johnson, chief investment officer at First Albany, which manages about $650 million. Those sectors have also been the best performers since Sept. 21, Johnson noted.

First Albany manages funds for college endowments and other conservative investors, so Johnson has been restrained from jumping full-bore into the new bull market thesis. In late November, First Albany did increase its equity allocation to 55% from 45% for accounts in which 65% is the maximum exposure.

The firm has adopted overweight positions in consumer cyclicals, where holdings include


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Home Depot

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; basic materials, including


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; and industrials, including

United Technologies




. (First Albany is "comfortable" owning Tyco, Johnson said, although the stock was pressured this week by renewed concerns about its accounting and a possible



However, First Albany has not taken an overweight position in technology or a more aggressive stance on the market as a whole for one key reason: valuation.

"I don't hang my hat on it, but too much optimism and the market being overvalued are reasons to raise the yellow flag," Johnson said.

The fund manager doesn't place a lot of emphasis on any one particular sentiment gauge. But a commonly used one, the Chicago Board Options Exchange Volatility Index, fell 1.4% this week to 22.02, a level that has accompanied

market tops in the past year.

How High Is High?

At week's end, the S&P 500 was trading at a price-to-earnings ratio of 23.8 times projected 2002 earnings. The forward P/E of the S&P Tech Index, meanwhile, was at 63, according to Baseline.

Bottom line: The market ain't cheap based on prospects for the economy and corporate profits.

"I don't think the economy is going to necessarily heal as quickly as the equity market believes," said John Lonski, senior economist at Moody's, who is actually fairly optimistic about the economy's prospects for the coming year. He believes the recession will officially end sometime this quarter.

Lonski actually expects fourth-quarter 2001 GDP to be higher than first-quarter 2002 because of the "spectacular success" of automakers' 0% financing and a still-strong housing market. But he expects average quarter-to-quarter GDP growth of 4% in the final three quarters of the year.

The problem is, robust year-over-year increases in corporate profits are unlikely until the fourth quarter because "companies will have a hard time widening profit margins as long as capacity utilization remains under 80%," he said. "Even though the growth I'm forecasting is stronger than consensus, it's not strong enough to boost capacity utilization up to a level that might be considered beneficial for profit margins."

A combination of higher stock prices and still low capacity utilization rates might trigger an increase in mergers and acquisitions, the economist said. That would benefit brokerages -- which rallied Friday after Prudential Securities upgraded several big names -- and result in a diminished supply of stock; both would be positives for the market.

"But the equity market is pricing in a recovery in profitability that might not be materializing until the second half of this year," Lonski said.

Another reason for valuation concern is that the big gap between the annual rate of increase in broad monetary aggregates -- such as M2 at 10% and MZM at 21% -- and the yield on the 10-year Treasury "practically assures that that 10-year Treasury yield will be higher by at least 50 basis points 12 months from now," Lonski said.

On Friday, the price of the benchmark 10-year note fell 4/32, to 99 2/32, its yield rising to 5.12%.

The optimism of equity strategists such as Abby Cohen of Goldman Sachs is based largely on an expectation that 10-year Treasury yields will decline amid rising economic growth. "I don't buy it," Lonski said, arguing that the recent upturn in industrial metals prices and back-to-back 0.5% increases in wages in the employment report "tells me the U.S. economy may not be entering into another phase of disinflation."

Recent history -- this week included -- has shown that stocks can become overvalued and stay overvalued if there is enough investor enthusiasm. "We're all worried about valuations, but none of us is brave enough to jump off the train," Johnson said.

Aaron L. Task writes daily for In keeping with TSC's editorial policy, he doesn't own or short individual stocks, although he owns stock in He also doesn't invest in hedge funds or other private investment partnerships. He invites you to send your feedback to

Aaron L. Task.