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THE TRIUMPH OF THE NEW ECONOMY

A powerful payoff from globalization and the Info Revolution

It was a good year to be an optimist. In 1996, defying the warnings from skeptics, investors big and small shoveled money into the U.S. stock market, which hit record after record. Over the past year, despite the recent correction, the Standard & Poor's 500-stock index has returned 20%, plumping up many a brokerage account and retirement portfolio. Since the beginning of 1995, the market has gained an astounding 65%.

Is the market crazy? Hardly. Underlying the equity boom is the emergence of a New Economy, built on the foundation of global markets and the Information Revolution. Starting in the early 1980s and accelerating in the past few years, the U.S. economy has been undergoing a fundamental restructuring. Exports and imports, once relatively insignificant, now amount to 26% of gross domestic product. Business investment in computers and communications hardware has soared by 24% over the past year alone, accounting for almost one-third of economic growth. From the Internet to direct-broadcast television, new companies are springing up almost overnight to take advantage of cutting-edge technologies.

GREEN LIGHTS. The stock market's rise is an accurate reflection of the growing strength of the New Economy. Productivity growth, although understated by official statistics, is rising as companies learn to use information technology to cut costs, a necessity for competing in global markets. Inflation, as measured by the gross domestic product price index, is at 2.1%--its lowest level in 30 years--and falling (chart, page 70). Interest rates are low, and corporate profits, adjusted for inflation, have soared by 50% since 1991.

For investors pondering 1997, the current shift to the New Economy will create opportunities to profit in the coming year. The stock market, propelled by low interest rates and rising corporate profits, could show a solid rise in 1997 (page 78). Technology stocks, from giants such as IBM to small networking and software companies, are positioned to benefit from the next stage of the Information Revolution (page 86). Financial-service companies, which already saw good stock gains last year, could rise even more if inflation stays low (page 90). Companies with strong positions in Asia and Europe will be winners if those economies take off in 1997, as many expect (page 100). Meanwhile, continued low inflation will likely make bonds more attractive to investors (page 136).

True, the New Economy has not abolished the business cycle. The market could surely be knocked for a loop in the unlikely event of a recession in 1997, or if inflation unexpectedly surges, forcing the Federal Reserve to raise interest rates. Indeed, Fed Chairman Alan Greenspan seemed to suggest, in a Dec. 5 speech, that he was worried that the stock market had risen too high.

But despite these risks, the New Economy is fundamentally favorable for investors. Take globalization, for example. Access to foreign markets is providing U.S. companies with a new source of profits. Exports have risen by 14% since 1994, three times as fast as the overall economy. Moreover, the export statistics do not include more than $1.5 trillion in production and sales by foreign affiliates of U.S. multinational companies.

NO BOTTLENECKS. At the same time, the growth of the global economy also lessens the danger of inflation, one of the biggest threats to investors in the 1970s and 1980s. It used to be the case that prices would start to rise whenever U.S. businesses started running near full their capacity--but this is no longer so. Now, with semiconductors coming from Malaysia and Ireland, toys coming from China, and software coming from India, it's much less likely that bottlenecks will develop. Indeed, over the past year, the price of nonoil imports into the U.S. has dropped by 1.6%, led by a 3.6% decline in the price of Japanese imports. And worldwide capacity is continuing to expand: According to projections made by DRI/McGraw-Hill, global spending on productive assets such as computers, machinery, and buildings will rise at a rate of 4.0% annually over the next few years, compared with a 2.8% growth rate for consumption.

The other cornerstone of the New Economy is information technology. Businesses now spend $212 billion per year on computer and communications hardware, in addition to tens of billions on software and systems development. In contrast, the spending on industrial machinery is less than $130 billion.

The benefits of such expenditures show up in the form of higher productivity and increased corporate profits. True, official government statistics don't show much of a productivity gain in the 1990s. But a recent report by two Federal Reserve economists suggests that the government's figures understate true productivity growth by at least a half a percentage point a year. ''The productivity statistics border on the unbelievable,'' says Allen Sinai, chief global economist at Primark Decision Economics Inc. ''Everywhere I look, the measurements seem suspect.''

But even the government data are showing signs of productivity improvements. For example, productivity at nonfinancial corporations, which account for the great majority of businesses listed on the nation's stock exchanges, has increased at a 2.5% rate during the past year. By comparison, the growth in productivity at these companies averaged only 0.2% in 1988 and 1989, at the end of the previous recovery.

The impact of higher productivity on stock values can be astounding. Adding one percentage point to long-run productivity growth can sharply raise the stream of future earnings. That could potentially boost stock prices by some 20%, accounting for much of the rise in recent years.

DANGERS. Moreover, with inflation dormant, there's a good chance that interest rates will stay in line or even decline, helping boost stock prices even more. Interest rates for high-grade corporate bonds, for example, are averaging 7.4% in 1996, down from 1994 nand 1995. According to Macroeconomic Advisers, a forecasting firm based in St Louis, the interest rate on 30-year Treasury bonds will average 6.49%, compared with 6.68% in 1996. Rates could go down even further if Washington manages to pass a balanced budget in the coming year (page 76).

What could go wrong? Some economists worry that the New Economy is still vulnerable to inflation, especially if Japan and Europe pull out of their slumps in 1997. ''The global economy could be so strong that it will finally give you inflation,'' worries David Hale, global chief economist at Zurich Insurance. Higher inflation could cause the Federal Reserve to raise interest rates, pulling the markets down with it.

The alternative, a sharp economic slowdown, could be equally distressing to investors. While the odds of a recession over the next year are low, slow growth could force companies to cut prices, badly hurting profits. ''The big worry is not the old risk of reflation, it's the new risk of deflation,'' says Edward E. Yardeni, chief economist at Deutsche Morgan Grenfell.

JUGGLING RISK. Even in the absence of such calamities, the New Economy certainly offers no guarantees to investors. In the second half of 1996, 32 out of 90 Standard & Poor's industry groupings declined in value, despite a 8% rise in the overall market.

What's the best way for an investor to deal with these risks? One option is to look for stocks that might become takeover candidates in 1997, as companies adjust to the New Economy (page 96). Investors can follow the advice of top professionals (page 122) or contrarians who try to find picks that the market has missed (page 114). For the analytically minded, the Investment Outlook Scoreboard screens companies by several different investment criteria, including dividend yield (page 155).

The wary investor can try to find ''old economy'' companies that are doing well (page 94), or alternative investments to stocks, such as real estate investment trusts (page 142), commodities (page 146), or art (page 148). Some hedge funds are adopting ''market neutral'' strategies to minimize the damage done by a market decline (page 110).

Ultimately, the strength of the markets depends on the wealth of the underlying economy. And by that measure, investors are in quite good shape, thank you.

By Michael J. Mandel in New York



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