Remember January?

That happy month not so long ago when everything seemed to make sense again, the worst appeared to be over, and the light at the end of the slowdown tunnel loomed just six months out? Predictions that the economy would recover in the second half of 2001 were solidly in place, and investors began "looking across the valley," as so many talking heads put it, buying up stocks in anticipation of that moment. Tech stocks climbed steadily, and the

Nasdaq rose 16% in just three weeks.


Paul Sagawa
Senior Research Analyst
Sanford C. Bernstein

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Now that stocks have erased all and more of those gains, January is nothing but a fond memory. Where to lay the blame? Blame it on that nasty little concept called

visibility. Toward the end of January, companies began owning up to the fact that, really, the economic and earnings pictures were so foggy that there was no way to draw an accurate forecast. The real drubbing began in early February when communications supplier heavyweight

Cisco

(CSCO) - Get Report

joined the "invisibility" fray, saying the company's

ability to forecast trends on capital spending was poor, and that it had effectively stopped all hiring. And then, just a week ago,

Nortel

(NT)

called the U.S. economic slowdown

"faster and more severe" than it had expected. Suddenly the valley looks a whole lot wider and deeper than investors had thought.

So when is this so-called visibility problem going to clear up, and what does a recovery in the economy and earnings look like now?

For today's Daily Interview, we spoke with Paul Sagawa, senior research analyst at

Sanford Bernstein

, about these issues from the perspective of the telecom equipment industry, his specialty. Sagawa has covered this sector for a little more than four years at Sanford Bernstein. Before that he did strategy work for communications technology companies at one of the world's top management consulting companies,

McKinsey & Company

, for 6 1/2 years.

How does the market price in a lack of visibility? If there is so little certainty about earnings and revenues, how can they be accounted for in the prices of stocks?

Sagawa:

I think the market is pricing in the lack of visibility right now. I think the market gave too much credit to visibility before. Because, I actually don't think that any of these technology providers ever had any visibility, but what passed for visibility was the tendency for things to remain the same. So they were forecasting with a rearview mirror. Which works nicely on a straight road, but when you get a dip it does you no good at all.

Where is the bottom when you're talking about such a foggy scenario?

Sagawa:

Well, at least in telecommunications we're talking about cyclicals. People believed this sector was a constant growth business when actually it was cyclical. And we're heading into a sharp down cycle now. What usually happens in down cycles is that the market overreacts, and it doesn't make sense on a rational basis. So that even though many of these stocks seem to be trading on what seem to be fair valuations, nothing says that these things can't go lower. And the momentum that drove these stocks so high -- momentum works on the way down too. So if these stocks saw valuations in June that were absurd, then its also probably likely that in retrospect, we'll see valuations that will seem absurd on the downside too. Picking a bottom is hard, because you can't use rational thought to pick where it is. So I think we're going lower, and its much more of a momentum based opinion than it is based on the value of the companies.

How can people predict we'll see a recovery in the second half of 2001 if visibility is so poor?

Sagawa:

I think people are backing off from that right now. I mean we've already had two of the largest telecommunications suppliers, Cisco and Nortel sort of admit that, you know, that a rapid V-shaped recovery in spending is unlikely and I think the facts of the matter make it highly unlikely. So I think at this point, the buy-side is getting more and more skeptical. And I think that's showing up in this recent drop in prices.

Is there a new forecast for recovery?

Sagawa:

Well, people are sort of all over the map. I have my own forecast. I actually don't think we see it until well into 2002. I think that at this point, most of the investors have at least written off 2001, but they are hoping to see signs of recovery looking into 2002.

You have to look at how bad these warnings were. Cisco and Nortel didn't just miss their numbers. They basically missed them by a country mile. When they missed them, they said, "We can't see very far into the future, but what we can see doesn't look very good." Meanwhile, Cisco's CEO John Chambers has been out commenting that the economic conditions look like a recession and Nortel is struggling right now over this

JDS Uniphase

(JDSU)

deal, and they closed a major acquisition a day before announcing. It's left them with egg on their face, too.

What is the range of possible recovery scenarios right now?

Sagawa:

I've heard three letters: V-shaped, U-shaped and L-shaped. L-shape is obviously no recovery at all, or so far out that we can't even imagine it. When people say U-shaped, usually they're talking about recovery some time in 2002. Now, I'm specifically talking about the telecom sector. So the economy as a whole may be somewhat different. I'm tracking the ability of telecom carriers to foot the bill for these telecom investments. The V-shaped theory is the mythical second-half rebound, which I think has little support from most investors. With the U-shaped recovery, I don't mean the first month of 2002. I would say look out 18 months from now.

Which scenario are most analysts and companies gravitating toward right now?

Sagawa:

I think we're seeing more U's and we're starting to see some L's. If you looked at it in December, the majority of people were expecting a sharp recovery in the back-half of 2001. That has fundamentally shifted now. I think now that most people aren't expecting until the end of the year.

What do you think the recent data indicating there may be some inflation threat does to visibility?

Sagawa:

Well, I'd say two things. First, I think that the reason we are seeing slowing spending in the telecommunications carriers, isn't so much that the economy is so bad. It's more that the sector has over-invested for several years and became so indebted that its ability to borrow more money to fuel continued spending came to an end. And that's really why they stopped spending. In fact, actually, I would argue that the circumstances in the telecommunications sector had more to do with the economy faltering than the economy faltering had to do with the troubles in the telecommunications sector.

So I don't think even the recovery of the national economy means that this sector is going to be off to the races necessarily. The stock market certainly reacts a lot to the perception of the climate for further rate cuts, and the inflation data sort of puts the breaks on any aggressive rate cutting by the Fed. Even though the Fed wants to defend the economy, it is even more vigilant against allowing inflation.

I think the Fed is worried about something called stagflation, which was pretty insidious in the 70's. I'm not an expert on the Fed. I'm just sort of going on what I hear out there. But it makes sense to me.

What about the rate cuts made so far -- shouldn't they account for something?

Sagawa:

Well, they've already kicked in. But it depends on how the rate cuts actually work on the economy. In the carriers' case, the problem isn't so much that all of the sudden there's no money being lent. It's that the money that's being lent isn't going to risky projects like telecommunications. So it's a risk issue, not a money supply issue. The corporate market tends to be a little more responsive to interest rates, so that area, which has been weak in terms of capital spending, could pick up. But remember, IT capital spending in corporations tends to follow corporate profits. So until we start seeing profitability rise, it will be hard to project a rebound in capital spending. And the third thing is consumer spending, probably the most responsive to interest rate cuts. And we ought to have the most hope that the spending rebounds there.

Do you see any sectors outside of telecom that might be less immune to visibility concerns?

Sagawa:

Undoubtedly, there's someplace where somebody's got a good idea that's going to grow like heck. In my sector, I can see some areas that are better than others. But on the whole the sentiment is so bad that it's even hard for me to say with great confidence that you'll make a near term return in any stock in my sector. That said, I think that consumer spending has a greater likelihood of rebounding more quickly. For that reason, I like companies like

Nokia

(NOK) - Get Report

or

Palm

(PALM)

, because I think their sales will rebound more quickly. These stocks have been beaten down and sell primarily to the consumer market. And both are high-quality companies with great products, leadership positions and great management. So, that's where I'd start now. I don't have a perfect crystal ball. And expect that sentiment in the sector is going to be bad for a little while. But that's where I'd be putting my money if I were going to be investing in communications technology.

So how do these visibility issues crop up, and how could they be avoided?

Sagawa:

I think that when the companies talk about visibility, what I really think they're talking about is their own sense of confidence. One would argue that in July of 2000, the companies that thought they had visibility had little, but what they did have was misplaced confidence. And that level of confidence has plunged with every shocking decline in earnings. There's a large degree of distortion that happens inside the company as it goes up the chain of command. The salespeople talk with management, and tend to guild the lily anyway. The salesmen get their information from the customers. And there it's the engineers that are communicating with the sales people.

The engineers are biased. They always want to build the best. So they're late to tell the sales people bad news. And the engineering side already has the issue of distorted information, because they're being told budget numbers from the financial side of their business. There is a constant war between the engineers and the financial side. And the engineers have always been able to go back and get more money later. So they have a natural skepticism about the conservatism of the accountants. So when they're told a budget figure, they instantly go back and add 25%. Until there is some sort of enforcement, they'll remain biased. So there is another lag delay, distortion. Finally, the financial side needs to raise money from the capital markets. Capital markets have been telling telecom carriers since midsummer that they're not interested in providing more funding. And the accountants have been sort of trying to bide their time, thinking the capital market will open up again. And it really doesn't look like it's going to happen. So finally, the accountants begin to believe the capital markets. And the accountants put the screws to the engineers, who are forced to cut nonessential investments. Finally it gets to top management of these companies. And this is the same process that happens at all of these companies.

If top management also did independent analysis of the capital markets, and whether or not their customers were going to be able to finance the deals, they might have come to a different conclusion.

Sagawa said Sanford Bernstein doesn't do any underwriting for any of the stocks mentioned in the interview.