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When Wealth Is Blown Away


As the old Wall Street joke goes: "Now I'm in real trouble. First the laundry called to tell me they lost my shirt, then my broker called to tell me the same thing." But with the Nasdaq down over 60% from its peak, the Standard & Poor's 500-stock index down 23%, and the Dow Jones industrial average down 12%, that's no joke. Many terrified--and suddenly poorer--investors now sit paralyzed on the sidelines. Afraid to buy, but reluctant to sell, they fear cashing out at the lowest point of the market and missing a sudden upswing or turnaround.

They could be waiting a long time, despite the fact that everyone from Wall Street strategists to CNBC pundits have been alluding to a market bottom for months. "You've got some expert calling a bottom every time there's a half-day rally--some have called 10 bottoms in the last three to four months," says Bill Meehan, chief market analyst at Cantor Fitzgerald. These gurus are focusing on such conventional market measures as price-earnings ratios, earnings forecasts, and interest-rate cuts. They are overlooking the fundamental event that took place in the market in the last year--that $4.6 trillion in investor wealth has vanished since the market's peak.

This loss, representing almost half of Gross Domestic Product and over four times the amount of wealth wiped out in the 1987 crash, holds enormous consequences for the U.S. economy and the stock market itself. Back when stock prices were surging, consumers felt flush with cash, and they engaged in a spending frenzy. The rising stock market added about one percentage point a year to economic growth over the last five years, according to Stephen Roach, chief economist at Morgan Stanley Dean Witter.

But now the plunge in stocks has them holding onto their wallets for dear life. This "unwealth effect" could lead to more cuts in consumer spending and further depress corporate profits, sending the stock market into a downward spiral. "It's going to be sharper on the downside than it even was on the upside," says Roach.

Investors are building up their cash positions. They're avoiding putting new money into a stock market where peril seems to lurk at every turn. Corporate earnings projections continue to be revised downward, companies are issuing record numbers of negative earnings warnings, and every day there are new reports of layoffs and bankruptcies. Technology companies are spooking investors the worst, as tech spending continues to slow and earnings projections are slashed.

Adding to investor woes are growing dangers abroad. In Japan, the Nikkei recently fell to its lowest level since 1985. And on Mar. 14, 19 Japanese banks were put on negative credit watch by Fitch Investors Service Inc., the rating service, raising questions about the viability of the Japanese banking system. That sent stocks of U.S. companies from Merrill Lynch (MER) to Boeing (BA), as well as U.S. banks like Citigroup (C), swooning. And analysts in Europe are slashing earnings forecasts. So far this year, stocks are off 10% in Britain and Germany. The benchmark DAX index is back to its level of Nov., 1999.

The supposed stock market cure-all--interest-rate cuts by the Federal Reserve--has had little effect so far. And the next one--50 to 75 basis points expected on Mar. 20--is already priced in. "People are saying they don't have any sense of how to know when it's over," says Charles H. Blood Jr., senior markets strategist at Brown Brothers Harriman & Co.

This fear hit home even more on Mar. 12 when the tech-heavy Nasdaq was walloped the hardest, falling below 2,000 for the first time since Dec., 1998. And as profits worries continued to spread beyond tech, the Dow dropped 4.1% and the S&P was hit with its fifth-biggest point loss ever, finally slipping into bear territory--23% off its peak. Despite a brief recovery on Mar. 13, the market's carnage resumed on the 14th, with the Dow falling under 10,000 for the first time since October.

"THAT CON GAME." Instead of buying on the dips--the prevailing stock strategy during the bull market--investors are stockpiling cash. "Last year investors were saying, `I bought something and it quadrupled, and I'm retiring at 29.' Now they're saying, `I'll never go near that con game again,"' says Jim Griffin, chief strategist at Aeltus Investment Management Inc. In the first two months of this year, investors poured unprecedented amounts of cash into money-market funds, raising the total money-market assets to a record $140 billion, according to AMG Data Services. And although Wall Street holds that money on the sidelines is a bullish sign, insisting investors are likely to plow that cash into the stock market at any given moment, the likelihood of that happening until the spate of bad earnings news runs its course looks slim. "People can get better returns in money markets and bonds by far, and perhaps even in overseas markets. So the notion that the stock market is the only place to get returns is no longer true," says Cantor Fitzgerald's Meehan.

Typical is Jack P. McDonald, 60, of Akron, Ohio, who owns a children's furniture franchise in Cleveland. McDonald says he took money he would have invested in the stock market and put it toward another retail franchise because "I can control what goes on there more than I can in the market." He also has some $100,000 in savings that he could put into the market at any time, but he's waiting to see if Alan Greenspan will cut rates enough or if a tax cut will spur the economy.

Certainly, many Wall Street strategists continue to predict a Fed-induced economic rebound which will propel the market higher. "The recovery is being actively engineered by both Mr. Greenspan and President Bush," says Edward Kerschner, global investment strategist at UBS Warburg. Some point to other bullish signs in the market: Margin debt has fallen sharply in recent months, expunging excesses. Also, historically when a bear market has spread to the more conservative areas of the market, it often means a bottom is near.

The reluctance on the part of investors to put their money to work in stocks explains in part why the Dow and S&P have fallen into a slump along with the Nasdaq. Whereas investors were recently taking money out of New Economy stocks and putting it into Old Economy stocks, now they are simply removing that money from the market altogether and building cash positions. On Mar. 14, all 30 Dow stocks ended up in the red for the second time in a week during which stocks like General Electric Co. (GE) hit a 52-week low. "Investors thought GE, a superbly managed company, was a great place to put money and avoid earnings hits in tech companies. Ditto for Coke (KO), Philip Morris (MO), and others. But now they're afraid to touch even these companies," says Charles J. Pradilla, chief investment strategist at SG Cowen Securities Corp. Year-to-date, 9 out of 11 sectors in the S&P 500 are in negative territory.

GRUESOME NUMBERS. The reason for the increased caution: eroding earnings expectations. Analysts have been racing to ratchet down earnings forecasts. At the beginning of the year, earnings for the S&P 500 were projected to grow 9.2% for 2001 over last year, but now they are expected to rise only 2.7%, predicts First Call Corp., the earnings research firm. "The numbers are gruesome by anyone's standards, and they are going to keep falling fast," says Joseph S. Kalinowski, equity strategist at First Call.

For all that, technology is where the most dramatic earnings erosion has taken place. Profit estimates for high-tech companies have been dropping almost daily for the last five months, but many pundits believe Wall Street's expectations are still too high. The Street expects a 29% drop in first-quarter tech profits, followed by a 27.5% decline in the second quarter, a 15% decline in the third quarter, and a 9% gain in the fourth quarter. But following a spate of announcements in recent days--from the likes of Yahoo! (YHOO), Cisco (CSCO), and Intel (INTC)--that things will continue to deteriorate well into the fourth quarter, even that scenario looks optimistic. "Those numbers are writ in water," scoffs market strategist Laszlo Birinyi of Birinyi Associates in Westport, Conn.

So how much farther could stocks fall? Despite the sharp declines, some think valuations remain too high. The Nasdaq Composite Index sells at 45 times forward 12-month earnings, while the S&P 500 trades at a p-e of about 24. Though Nasdaq's p-e is down from its Mar., 2000, high of 81, it remains well above historical norms. Still, the faster growth and stronger productivity of the New Economy may justify higher tech stock valuations than they have averaged in the past.

That said, if current earnings estimates for tech companies prove too rosy, then their p-e's will turn out to be even higher. And that looks to be the case with many industry heavyweights. The Nasdaq's big kahuna, Microsoft Corp. (MSFT), with a 30 forward p-e, has seen profit estimates cut to 1.1% growth from 4.4% early in the year. But Credit Suisse First Boston analyst Wendell H. Laidley worries that Microsoft will not make its numbers. The reason: While most analysts expect the PC industry to grow slightly in the first quarter, he thinks it may shrink by 2.4%, and 69% of Microsoft's sales come from PC desktop software.

Or take Intel Corp., the second-largest tech stock and premier chip company. It trades at a 41 forward p-e and is already down 61% from its 52-week high. But the consensus forecast calling for steady profit gains in the second half is a pipe dream, warns U.S. Bancorp analyst Ashok Kumar : "The question is, the second half of what year?"

Some market pros say all that might be needed to turn tech prices around is for a few large companies to signal growth rates aren't declining as much as they had thought. "You need tech stocks to pull out of this because they're so heavily weighted in the overall market indexes, as well as in investors' portfolios," says Arnold Kaufman, editor of Standard & Poor's Outlook investment newsletter.

But that signal may be a long time in coming if the economy continues to weaken. And the reverse wealth effect makes that all the more likely. The biggest destruction of wealth has come from the Nasdaq's plunge and, according to at least two economists, Ed Hyman from International Strategy & Investment, and Ian Shepherdson from High Frequency Economics, it is beginning to take a toll on consumer spending. According to Hyman, since 1996, dips and rises in the growth rate of consumer spending closely track the movements of the Nasdaq. Judging from Nasdaq's latest tumble, Hyman believes consumer spending has a lot further to fall. Morgan Stanley's Roach says that investors will start saving income once they realized the stock market isn't building wealth for them. That will chill the economy. An early warning sign: Retail sales fell 0.2% in February after rising 1.3% in January.

Many economists dispute that a reverse wealth effect automatically means bad things for economic output and consumer spending. They contend that the effect is inconsistent. But people who do expect a serious spending hit from the stock market point to the fact that the market's slide has been unusually large and rapid this time. In fact, a recent Fed report said that tumbling stock prices caused household net worth to fall last year for the first time since the Fed began keeping records in 1952. And that's sure to make people tighten their purse strings, says Hyman. Consider Anurag Agarwal, 57, a retired GE project manager from Voorhees, N.J., who lost $900,000 of his $1 million portfolio last year. He says he's driving less, reducing the thermostat and has cut four telephone lines to two. "When the market bounces back a bit, I'm going to get out forever," he says.

The bear market of 2001 has caused plenty of damage already, but plenty more people could lose their shirts. No joke. By Marcia Vickers in New York, with Geoffrey Smith in Boston, Peter Coy and Mara Der Hovanesian in New York, and bureau reports


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