December 13, 2001

Last week the Dow Jones crossed 10 K while the Nasdaq index exceeded 2 K. Neither of these were records. Indeed, 2000 is far below the 5000 reached by the Nasdaq early in 2000.

Nevertheless, this substantial improvement from late September, raises the question of whether this rally is sustainable, ahead of events, or another sucker rally such as last spring that evaporated with the poor earnings reports of July and August.

Although the economy is in recession, stock market rebounds usually anticipate a shift in economic growth by 4 to 6 months. If this pattern remains appropriate, to be sustained, this stock market improvement must be predicting the end of recession between January and March of next year.

Many economists see improvement next year, but not until late in the spring or early in the summer. If so, a substantial pullback in this stock market advance should be expected before more sustained gains are likely.

My own forecast is that the economy will rebound before the end of winter. Of course, I am assuming that the pessimistic consumer will respond to falling inflation and equity withdrawals from refinanced homes rather than allow fears of future economic conditions to dominate spending decisions.

Economic theory suggests that both consumer attitudes and consumer capacity to spend are relevant. My own forecast is banking upon Christmas spirit to overcome depressed attitudes, an assumption that certainly is not guaranteed.

At least I get some solace in my economic forecast by observing that the stock market is consistent with similar predictions.

If the timing of the market advance is appropriate, it still is relevant to ask whether the magnitude of the advance is in order.

Here, I differ with current market performance.

In the past year, operating profits have declined 21 percent. While improvement is likely in 2002, profits probably will not be above previous year levels until late spring or early summer. Certainly, stock values are down only about 8 percent in contrast to the collapse in profits.

Fortunately, the value of future earnings depends not only upon the level of those earnings, but also upon the interest rates that prevail.

I have always argued that long term interest rates are relevant here. While short term rates have fallen by more than half in the past year, long term rates are down only about 15 percent. Furthermore, those rates have been rising during the most recent surge in stock market values.

In other words, the improved interest rates will justify a lower decline in stock values than the decline in profits, but probably not enough to support current stock market levels. In short, the stock market probably is 5-7 percent ahead of anticipated economic conditions at this time according to my estimates.

But how can the market be wrong? Of course, it was wrong 18 months ago when Nasdaq was above 5000. Speculative excesses accounted for those results. What could be making the markets wrong now.

Two factors come to mind. First, the Federal Reserve has pumped a lot of liquidity into the economy to make sure that the recession is mild. Some of this liquidity has flowed into equity values.

Second, investors cannot forget the high prices that some of these stocks previously commanded. They do not yet believe that 80 per share for a Cisco was wrong, and they are hoping it will get back there soon. Such holding of price targets above sustainable levels is not unusual following a speculative surge. Another setback will be necessary before investors settle back to accepting $20-30 as a more reasonable value.

Because of the liquidity, I do not believe that a correction from this rally will be meaningful before the beginning of year investment surge has run its course. However, I would be looking for a significant pause about the beginning of February before improved earnings finally justify higher equity values later in the year.


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