BUSINESSWEEK ONLINE : APRIL 17, 2000 ISSUE
COVER STORY "Ultimately, the Market Gets Priced on Fundamentals" PaineWebber investment guru Mary Farrell takes a long-term view of the current volatility While investors try to digest this week's wild ups and downs and ups of the market, Mary C. Farrell, managing director and member of PaineWebber Inc.'s Investment Policy Committee, says buy and hold -- and this, too, shall pass. An investment analyst for more than 24 years, the last 18 at PaineWebber, Farrell is one of the best-known strategists on the Street. Most investors will recognize her as one of the frequent panelists on Wall $treet Week with Louis Rukeyser. Recently, she published a new guide to investing called Beyond the Basics: How to Invest Your Money, Now that You Know a Thing or Two. Business Week Online's Margaret Popper spoke to Farrell on Apr. 6 about the state of the market. Here are edited excerpts of their conversation: Q: Are we on the verge of a meltdown? A: Meltdown would apply only to the Internet stocks that don't have earnings. We've already seen the beginning of an extreme correction, which was really long overdue. A lot of [Web startups] have gone public and achieved stock prices that were unjustified by any fundamentals and clearly unsustainable. But for the rest of the market, the fundamentals remain intact. Q: What's going on between the Nasdaq and the Dow? A: Last year, the Nasdaq was up about 81% to 83%. That was an extraordinary move and somewhat justified. In a reversal of the pattern historically, our largest companies now are getting some of the strongest earnings growth. If you look at the largest 10 companies in the S&P 500, most of which tend to be in the Nasdaq, they're companies that are growing 15%, 16%, maybe even 20%. So there was some rational gravitation toward the high-technology stocks that dominate Nasdaq because they were delivering the best earnings. But having achieved that 81% gain last year in the face of a 20% gain for the Dow, there was really an imbalance in valuation. I think this year began and once again, Nasdaq is performing reasonably well, notwithstanding the correction. But the [Dow] had gotten relatively so undervalued that we've seen a broadening of interest and movement in the Dow stocks. Q: Stephen Roach, chief strategist of Morgan Stanley Dean Witter has said volatility is just one of the ways the market addresses this disconnect in valuations (see BW Online, 4/5/00, "I Don't Think the Bubble Has Necessarily Burst"). What do you think? A: I think it's the escalation in trading that's causing this volatility, and you can't backtrack on technology. It's here to stay. I don't think the vast majority of individual investors are suddenly trading more, but there is a small group doing a great deal of trading. That does move prices rather quickly. Also, trading [has become] much easier because of technology and much cheaper. Institutions can trade for almost nothing. Q: How do day traders feed volatility? Do they see a movement, leap in like lemmings, and eventually set off institutional program trades? A: I wouldn't even give them that much credit. I think these day traders are gamblers, but they tend to be momentum players. So they just sit at the computer all day, chasing the momentum and hoping. They'll trade if they can book a sixteenth of a point, much less an eighth of a point. You refer to lemmings, and I think that's an excellent analogy. They're chasing the stock going up, and the second it starts going down, they're chasing it on the downside. They tend to exacerbate the moves and maybe make them faster. With all this volatility and rapid trading, I don't think any of this changes the ultimate direction of the market. That's one of the big messages of my book: Individuals are buying a future stream of earnings, and those earnings don't tend to be impacted by volatility in the market. So [individual investors] should overlook the short term. Let the traders, let the momentum players bounce the stock around in the short term. If you're confident of the fundamentals of the company, just hold it. Q: What are the fundamentals of the economy that make you say we're in a healthy period? A: Ultimately the market gets priced on fundamentals. It's inefficient in the short term, but it moves toward efficiency. In combination, earnings, interest rates, and inflation are what determine the [economy's] direction. Interest rates have been coming down since 1982. Future declines will be more moderate, but the long-term secular direction is downward. Inflation was the problem of the 70s and 80s, and devastating to financial assets then. It's not the problem today. We're seeing some wage increases that are more than adequately covered by productivity. The Federal Reserve has done an outstanding job of keeping growth going without inflation. And finally, corporate earnings -- this first quarter's earnings are likely to come in ahead of 15%. Last year's earnings came in up 14%. I think 10% to 12% is a realistic expectation for year 2000. On a very preliminary basis, a 7% gain next year looks realistic. Q: Is it important that Greenspan continue to shoot up rates periodically, or is he just fighting a losing battle? A: I think he has done a very good job. It's a very difficult job, because whatever he does doesn't impact the economy except with a lag. So you run the risk of doing too much and then having a cumulative effect. I think that just by the length of this economic expansion, we'll see some slowing coming up. As early as this quarter, but at least by the third quarter we will see some evidence that economic growth is slowing. It's accepted he'll raise [rates] in May, but I have a feeling the economic numbers won't suggest he has to raise them any further. Q: What's the risk that the tight labor market pushes us over into an inflationary period? A: At this stage, we have a long way to go before labor costs will curtail growth. I think we will see continued productivity offsetting any labor-cost increases. Labor is clearly getting tight, with the lowest unemployment in 30 years, but I think we'll see more investment in technology to reduce labor content. People thought you can't automate in the service sector, well you can. Just for an example, if you look at PaineWebber's research department. We have spent a fortune on technology. Research is delivered in our offices electronically. We don't print it. We don't stuff envelopes. We don't stamp them, mail them, and hope they arrive in the office a week later. We've saved a week. But that would not be measured as a productivity enhancement, although we think it is. We have been so fortunate with productivity. Government statistics can barely measure the productivity. They very significantly underestimate it. Especially because 80% of our employment is in the service sector, where it's hard to measure productivity Q: What's effect does the baby-boom generation have on the overall economy? A: It has a two-fold impact. One of them is if you look at equity investment in the 90s, it has escalated enormously. Baby boomers at the beginning of 1990 started flooding into that 45-54 age group. Which in the U.S. are your peak earnings and investing years. That [age group] continues to get larger through the year 2007, stays up there through 2012, and doesn't start declining until 2013. We could have another decade of very strong demand for common stock. Q: What should people be buying and holding now? A: For long-term investors, common stocks are really the best place to be. One major area would be technology, but let me emphasize the old New Technology stocks, not the Internets. The baby boomers are spending on their homes. Home Depot would fit in there -- Costco, Walmart -- the brick-and-mortar retailers that use the Internet. Carnival Corp. -- people are taking less vacations but they want more stress-free vacations. At the high end would be Tiffany. We're seeing almost a bifurcated retailing group. People want the cheap no-service online retailers, or they're willing to pay a premium for a high level of service and quality. What do you see as the key factors to watch over the next six months, one year, five years? I think key things will be that interest rates continue moving down -- however gradually -- that inflation stays at bay, and that this economic expansion continues so we can get good earnings. _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ BACK TO TOP					RELATED ITEMS Is the Party Over? COVER IMAGE: Wall Street: Is the Party Over? CHART: Tech Comes Back to Earth CHART: Internet Stocks Take a Dive TABLE: The Move to Quality Margin Calls: Not a Lot of Wiggle Room Time to Keep a Cool Head TABLE: Why You Shouldn't Sell in a Panic The Dot-Coms Are Falling to Earth TABLE: The Internet Shakeout Why Gates Is Rolling the Dice TABLE: Bill's Vision ONLINE ORIGINAL: "Ultimately, the Market Gets Priced on Fundamentals" ONLINE ORIGINAL: BW's Bill Wolman on the Stampede to Quality (Video) ONLINE ORIGINAL: Oppenheimer Funds' Marci Rossell on the Market in the New Economy (Video) INTERACT E-Mail to Business Week Online

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