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How Bad Will It Get?


It's March, and the bears are coming out of hibernation. More than $3 trillion of investment wealth has been wiped out since the stock market peaked a year ago. The tech-heavy Nasdaq Composite Index has long been bearish, of course, down 57% since its peak last March. The Standard & Poor's 500-stock index, now off 19%, flirted with bear territory for the last week of February. And the broadest measure of all U.S. stocks is there already, with the Wilshire 5000 Total Market Index down 23% as of Feb. 28--exceeding the 20% drop that's the usual definition of a bear market.

With a spate of bad news piling up, the worst may be yet to come. Consumer confidence is plummeting. Corporate earnings have vaporized. Overstocked businesses are retrenching drastically, leading to layoffs and plant closings. Capital spending dropped an annualized 0.6% in the fourth quarter--its first quarterly drop in nearly nine years. Even housing, the one sector that has been strong, slowed in January. "With all this blood and carnage, I've started calling it the Hannibal Lecter market," says Ned Riley, chief investment strategist at State Street Global Advisors.

Hannibal, the movie, is over in two hours. But there's little likelihood of a quick end to the bloodletting for investors, either in the U.S. or in foreign markets. They are also plummeting--in part because of the worsening U.S. scenario. Investors, who not long ago bought stocks on the basis of revenue-growth projections or Web site page views, have gotten worried--and are focusing again on recession-proof fundamentals such as cash on the balance sheet. And young investors, who have never experienced a bear market, are learning fast that the herd mentality that drove prices up can drive them back down. Investors of all ages are learning to play defense (page 45).

LOTS OF AIR. The only thing keeping stocks from sagging even further is the confidence of many investors that the Federal Reserve, which meets on Mar. 20, can stave off a recession with interest-rate cuts. If the optimists lose faith in the Fed's magical powers, all bets are off on Wall Street. While stocks have fallen a long way already, there's still plenty of air left in them: Valuations relative to earnings remain far above historic norms. Those valuations can be justified only by above-average growth in profits--and for this year, at least, profits will rise weakly if at all. "I think we're headed for negative earnings for the year," says Charles L. Hill, research director at First Call Corp., which compiles analysts' forecasts.

The trouble with casting Federal Reserve Chairman Alan Greenspan as Dr. Feelgood for a sickly economy is that the Fed's medicine, while powerful, is slow-acting. Economists say it can take nine months or more for a rate cut to work--too late for companies that are looking at starkly weakened order books today. Right now, in fact, the economy and market are still feeling the ill effects of six rate increases the Fed imposed in 1999-2000 to cool off an economy that appeared in danger of overheating. "The Fed would have to stage an inter-meeting cut, or cut at least 75 basis points [three-quarters of a percentage point] on Mar. 20 for the market to respond at this point," says James A. Bianco, president of Bianco Research.

Greenspan made no such promises on Feb. 28 when he testified to the House Financial Services Committee. Indeed, he seemed to go out of his way to signal that the Fed would not be stampeded into action by an unhappy market. Said the chairman: "Action for action's sake is not desirable." Investors who had been banking on a cut before the Fed's next policy meeting were dismayed. The Dow Jones industrial average fell 142 points, to 10,495; the S&P 500 fell 18 points, to 1,240; and the Nasdaq sank 56 points--or 2.5%--to 2,152, its lowest level since December 1998. "With the Nasdaq only about 125 points from turning into the biggest bear market in Nasdaq history, [Greenspan] needs to jump on easing," says James B. Stack, editor of InvestTech Market Analyst newsletter. "Until then, the market will be on pins and needles."

Greenspan continues to hope that the economy can dodge a recession, and he told Congress that the economy seemed to do better in January and February than it did in December. Nonetheless, in one of the bland convolutions he's famous for, Greenspan admitted "the risks continue skewed toward the economy's remaining on a path inconsistent with satisfactory performance."

SPOOKED. And how. It's a staggering turnaround for an economy that was roaring full steam ahead only nine months ago. America's vaunted tech sector has gone from being the engine of the economy into a dead weight. The outlook has deteriorated sharply even since the Fed's two January rate cuts. In the past month alone, a Who's Who of CEOs from the sector's best known companies--Cisco (CSCO), Intel (INTC), Nortel (NT), Motorola (MOT), even last year's fiber-optics superstar, JDS Uniphase (JDSU)--have announced sharply reduced revenue projections and have slashed profit forecasts.

But it's not just the raw numbers that have spooked the market. It's that most tech companies now seem to be looking at a much longer slump than expected. Many tech executives originally thought the bad news would be over by summer, as they worked quickly through excess inventories. But with customers across the country jamming the brakes on capital spending until the outlook becomes clearer, many of techdom's highest fliers are now projecting weakness well into the second half.

To be sure, history shows that when the Fed sets its mind to cutting rates, it can eventually reverse a stalling economy and a falling stock market. In 1992, for example, the economy and the stock market zoomed after the Fed cut the funds rate to 3%. "Never fight the Fed!" warns UBS Warburg strategist Edward M. Kerschner. If stock prices bounce back soon, this bear market may be forgotten as quickly as the 21% decline in 1990, which is now looked on as a mere blip in an 18-year bull market. What's more, a weak economy doesn't always mean weak stock prices. In 1982, S&P 500 earnings fell 18%, but the S&P 500 stock index rose 15%, notes the Leuthold Group, a Minneapolis investment adviser. Since World War II, stocks have actually done better in years when S&P earnings fell at least 5% than they've done in years when S&P earnings rose, says Leuthold.

That said, there's no doubt that Wall Street is an ugly place to be these days. Investor sentiment has shifted dramatically. Since January, retail investors have been pouring record amounts of cash into money market funds, while funneling less into equities. U.S. money-market funds received $103 billion in January, compared with just $25 billion flowing into stock funds, according to the Investment Company Institute. "Investors have been so surprised at all this bad news. As opposed to last year, when they saw no ceiling in the market, now they see no floor," says State Street's Riley.

Investor culture seems to be turning bearish as well. CNBC, once the unofficial mouthpiece for bull market exuberance, has been losing viewers. Viewership for CNBC's flagship show, Market Wrap, dropped 8% in January, and its midday Power Lunch was down 20%, according to Nielsen Media Research. And the audience for CNN's Moneyline was down 13% in January. "Who wants to watch business news when it's all so depressing? This sucks!" reads a post on an Internet message board devoted to chat about CNBC.

Investors have good reason for battening down the hatches. Stocks in 8 of the 11 S&P 500 sectors declined in the first two months of the year. Although technology continues to suffer the steepest losses, defensive groups such as consumer staples and basic materials are also getting hit. "It's all due to the economy and the fact that investor sentiment toward tech has broadened to other areas," says Arnold Kaufman, editor of S&P's The Outlook newsletter.

That's no surprise: Earnings forecasts are fast being lowered. Officially, First Call says analysts are projecting S&P 500 earnings to fall 4% in the first quarter from their level a year ago, and to fall 2.1% in the second quarter, before rising 5.4% in the third and 16.2% in the fourth. But First Call's Hill says he expects those forecasts to come down dramatically. Says Hill: "Optimism for a second-half recovery is starting to wane." And it's not just tech earnings projections--already down 8% this year--spoiling the broth. Projections for basic materials profits are down 11%, and consumer cyclicals are down 2%.

For investors, the No. 1 question is whether or not the economy will snap back quickly. If U.S. output for 2001 is plotted on a graph, will it be in the shape of a "V," or will it look more like a flat-bottomed "U," with two or more quarters of slow growth or even recession? Some economists even think the U.S. could catch Japan's disease and fall into an "L," where output falls off and then stays low for several years.

What would each scenario bring? Proponents of the "V" believe that the economy will snap back soon. Fed rate cuts will revive consumer confidence and the stock market. Housing will remain healthy. Once inventories have been brought back into alignment, businesses will speed up its output. And capital spending will recover. Indeed, some companies are sailing along fine. Even in Silicon Valley, the epicenter of the downturn, Oracle Corp. (ORCL) is sticking to projections of 30% revenue and profit growth expectations for the year. "From everything I can tell, it's business as usual," says Chief Financial Officer Jeff Henley.

But in recent weeks--influenced partly by downbeat earnings announcements from Cisco Systems Inc., Sun Microsystems Inc., and other tech stalwarts--market sentiment has shifted sharply toward the "U" scenario. In this picture, unemployment rises, debt-burdened consumers cut discretionary spending, and businesses reduce capital spending because of excess capacity. Falling stock prices don't help matters, discouraging consumers and making companies chary about investing.

Which letter prevails--"V," "U," or even "L,"--will depend in a big way on consumer confidence. Despite all the bad news, so far consumer spending has held up: Retail sales were up 0.7% in January from December, seasonally adjusted, and January auto sales ran at a rapid 17.1 million-per-year pace. But trouble may lie ahead. The index of consumers' expectations for economic conditions six months ahead--a component of the overall index--plummeted to 68.7 in February, down from 79.3 in January. Expectations are at their lowest level since October, 1993. "When you get consumer expectations nose-diving as they have in the past few weeks, the chance of avoiding a recession has more or less evaporated," says Ian Shepherdson, chief U.S. economist at High Frequency Economics, a Valhalla (N.Y.) economic consulting firm. Adds Ethan S. Harris, senior economist at Lehman Brothers Inc.: "The difference between a slowdown and recession often comes down to psychology."

LAYOFFS. Aside from consumer spending, the great unknown is the future of capital spending by business. Until the final months of 2000, it was rising far faster than the overall economy, creating an overhang of underused equipment, especially in information and communications technology. Now, cutbacks in capital spending are rippling through the supply chains, triggering layoffs and lowered profit forecasts.

The worst of the trouble, both for the economy and the market, has been in tech. Goldman, Sachs & Co. sees business spending on information and communications technology falling 8% this year, trimming about half a percentage point from economic growth. Goldman's worst-case scenario sees such spending falling nearly 20%. One recent victim: JDS Uniphase Corp., one of the highest fliers of recent years, which announced on Feb. 27 that it was laying off 3,000 workers, about 10% of its employees, because of slowing demand for its fiber-optic gear. Because IT spending accounts for 40% of overall capital spending and fuels productivity gains, a crash in the sector has severe repercussions for the entire economy.

But that's hardly the only sector hurting. Basic manufacturers are also feeling a chill. Although carmakers are expecting healthy U.S. sales--of 16 million to 16.5 million vehicles this year, down from a record 17.8 million last year--they say it will probably take rising rebates to move the metal. General Motors Vice-Chairman and Chief Financial Officer John Devine told Wall Street analysts in late February that he expects prices to continue falling in North America for a fifth straight year. "This is a lean year," Devine said. "Positive cash flow is not going to be easy." Steelmakers hope to fight the price erosion with a 10%-to-20% increase this month, but analysts doubt it will stick.

Still, Old Economy stocks are faring better than New Economy ones. Excluding tech and telecom, the median decline in the S&P is only 13%, says Jeffrey M. Warantz, an equities strategist at Salomon Smith Barney. The Dow is down only 10% from its high. And small-cap stocks are doing better than big-caps. "It brings back the reality that big-cap companies can't generate those high, double-digit growth rates with any consistency, due to competitive pressures," says Jeremy J. Siegel, finance professor at the University of Pennsylvania's Wharton School.

With growth slowing, the valuation of growth stocks appears to remain excessive by most measures. The average price-earnings ratio for the S&P 500 is now 25, compared with a historical median of 16, going back to 1926, according to the Leuthold Group, an investment management and research company. (The ratios are based on a running five-year average of earnings.)

Many economists believe that, in the long term, the New Economy can sustain a growth rate of perhaps 3% to 3.5%, above the historical average. That justifies somewhat higher p-e ratios, but perhaps not this much higher. If earnings don't rise, prices may have to keep falling. The buzz phrase on Wall Street among the bears is "mean reversion." According to a bearish analysis by Jonathan Lin of Salomon Smith Barney, it could take the market years of moving sideways--or a singular, spectacular drop--for the rate of price appreciation to get back to historical norms. For example, for the S&P to revert to its 10-year average annual gains of 15%, the index would have to lose 26% this year or go for three years with no gains.

Is there a silver lining in the rapidly gathering clouds? Possibly. Bulls argue that today's prices already reflect the bad news ahead. All the cash that investors have stockpiled in money-market mutual funds is itching to be deployed in stocks. So sooner or later, when the Fed's magic begins to work, the market could be poised for another run.

But if there's one maxim on Wall Street that's older than "Don't fight the Fed," it's "Don't fight the tape." Investors who once bought on the dips are now primed to sell on the rises--almost guaranteeing that any rally will be short-lived. Even when the market does start to pick up again, the glory days of the late 20th century, when stocks often rose more than 20% a year, are probably gone. Once it rights itself, the market is more likely to post annual gains of about 10%--the historical average over the past two centuries. But at the moment, that wouldn't look too bad. By Peter Coy and Marcia Vickers in New York, with Rich Miller in Washington, Charles J. Whalen in New York, Jim Kerstetter in San Mateo, Calif., and David Welch in Detroit


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