"I know you believe you understand what you think I said, but I am not sure you realize that what you heard is not what I meant."
-Alan Greenspan, Chairman, Federal Reserve Board

Don't fight the Fed! This age-old adage has proven painfully true for investors once again. The inscrutable Mr. Greenspan, whose mumblings sometimes are indecipherable at best, reintroduced himself over the last few quarters to a new generation of day traders, hedge fund managers, go-go mutual fund managers, Internet wannabes, and investment bankers who generated IPOs faster than bubbles from a wand. Between June 1999 and the end of second quarter 2000, Alan Greenspan and colleagues raised key, short-term interest rates six times. Prior to this, the Federal Reserve's most recent, extended bloodletting ran from February 1994 through February 1995. Then, as was the case recently, the impact on equity markets was distinctly negative. In 1994, the major stock indices declined for two quarters in a row. When the latest, greenest, "this-time-it's-different" investing crowds finally figured out that Greenspan meant what he knew he said, stocks fell through a trap door. The Fed's interest rate hikes, coupled with its squeeze on liquidity, contributed to this year's six months of market declines for the S&P 500, Dow Jones Industrial Average, and Nasdaq Composite - the only such long slide since 1994.

Ironically, even as it cited inflation fears as reason to slow the economy, the Fed itself contributed to the inflationary pressures. Remember Y2K? In the months leading up to 2000, the Fed was concerned with potentially calamitous events such as businesses and consumers hoarding cash and computers failing so widely that the economy would be crippled. From this position, the Fed probably had no palatable alternative but to inject liquidity into the banking system, even at the risk of fueling inflation. On January 1 this year, when the Chicken Littles of the world woke up, governments, corporations, and consumers were faced with remedial software adjustments only here and there, in an otherwise functioning world. The much-feared crisis turned out to be a colossal non-event - except for the manufacturers of batteries and bottled water.

Thanks in part to its own efforts to alleviate Y2K imbalances, the Fed's fears of irrational exuberance became a reality. During the fourth quarter last year and the first two months of 2000, much of the Fed's injected liquidity effectively fueled faster economic growth via increased business and consumer spending, and the Fed's cash infusion also found its way into heightened demands for stocks. By the end of March 2000, margin debt had skyrocketed to a record $278.5 billion, a 44% increase from the previous year. Hedge funds and aggressive growth-stock mutual funds were joined by giddy day traders seduced by a false sense of invincibility; they all became mesmerized by Internet and high-P/E tech stocks and the equities of hundreds of companies that were long on dreams but woefully short on revenues, and pushed them to dizzying heights.

Unfortunately, just as the Fed's preemptive money creation exacerbated speculation in climbing markets, the central bank's withdrawal measures fell on investors like a sledgehammer. When Y2K disappeared from the headlines, Greenspan and company began squeezing liquidity as if it were a great wet sponge, and continued raising interest rates. By redressing its flawed liquidity expansion and continuing to push up short-term interest rates, the Fed simultaneously pricked the tech and Internet stock bubble to which it had partially contributed, and helped deflate the potentially inflationary wealth effect of the stock markets. Starting in March, the equity markets tumbled and they plunged further in April and May. As the accompanying tables show, few indices were spared in the downdraft.

These negative numbers highlight the markets' extreme and widespread volatility during the first six months of 2000. Investors were taken on a whirlwind ride of almost daily, gut-wrenching market swings that relentlessly spiraled downward until sellers were exhausted in June. The contraction was especially severe among the richly priced, more speculative stocks traded on the Nasdaq. By the end of the second quarter, the average Nasdaq stock had declined 44% from its 52-week high. By the end of June, 80% of Nasdaq securities had dropped at least 20%. During the first six months of this year, the major averages careened like cannonballs on a storm-tossed ship; the Dow Industrials traded between 9,732 and 11,750, the S&P 500 between 1,325 and 1,553, and the Nasdaq Composite between 3,043 and 5,133.

Interest Rates and Valuations Matter

Perhaps the most significant development of the tumultuous, last six months is that the mantra of high-tech fliers - that higher interest rates would have no meaningful impact on technology stocks - has been snuffed out, and several stock sectors have imploded. In late 1999 and during the first quarter this year, most technology and Internet money managers and traders insisted that, because their favorite companies were growing rapidly, higher rates were of little consequence. What these devotees too easily dismissed is that higher interest rates do indeed affect valuations or P/E multiples. Now even the nonbelievers can see that, as interest rates rise, the higher the P/E on stocks and the more distant their future rewards, the more stocks' valuation levels, and hence market prices, will decline.

This truth began to unfurl in late 1999, when the Christmas season turned into a lump of coal for many Internet e-tailers. The process accelerated in spring this year. Acknowledging the immutability of valuations even for stocks with promising stellar growth, more and more investors dumped their secondary technology holdings. Yet, many diehard or hopeful investors still cling to larger, "safe" technology and Internet holdings, whose stock price adjustments are unraveling more slowly. These investors act like stowaways on a burning ship who scramble from the first deck to the temporary sanctuary of the second deck as flames intensify below. In recent weeks the valuation issue has further heated up, making larger tech stocks even more slender reeds. Ironically, as additional technology lions are being mauled, many Old Economy stocks, and also long-derided secondary technology stocks with decent prospects and sound financing, have stabilized and begun sprouting upward.

This strong lesson on valuations comes with another point: Even technology companies are subject to cyclical forces. It has bordered on supreme chutzpah for technology and Internet mavens to insist that higher interest rates and a slowing economy would not impact final demand for the products and services of the companies they champion. For months mainline retailers have labored under weak sales trends. In recent weeks signs of a slowdown have shown up in auto sales, housing, and durable goods. Those SUVs take a lot more dollars to fill the tank. The pinch on consumers inevitably will ripple from traditional retailers to specialty retailers such as Circuit City and other consumer electronic vendors, and then to the manufacturers of electronic components, microchips, and semiconductors.

Already the slowing economy and delayed reaction from Y2K front-end expenditures have slowed orders in the software and information technology industries. Companies such as IBM, Unisys, Computer Associates, BMC Software, Electronic Data Systems, Computer Sciences, and Ericsson have flashed yellow flags in recent weeks. And investors are seeing red. Whenever a company fails to deliver on the earnings expectations of the Street, it pays consequences in the form of severe stock price declines.

This summer likely will bring both more reassessment of the economy in the face of a vigilant Federal Reserve and continuing valuation adjustments before the cracked looking glass. The equity markets' ability to extend their recovery, which began in June and has carried into July, will depend on whether the negative influence of higher interest rates and weakening profits will outweigh nascent optimism that the Fed's work is done. In the aftermath of the 1998 Asian economic and monetary crisis, Old Economy companies have adjusted their cost structures. During the March-to-May period this year, many of these companies appeared to have ended their bear markets, which in many cases dated from spring 1998. While these companies might yet have to mark time or undergo some retrenchment in price, their relatively low P/Es already discount a period of slower growth. Technology stocks, on the other hand, might have more struggles ahead, especially the larger tech stocks that still are viewed by hopeful investors as safe havens during the unfolding market transition.

I'm from the Government and I'm Here to Help You

Other activities on the federal level may continue to weigh upon stock prices in the months ahead. Since 1994, the U.S. Department of Justice and other government agencies have pursued more than 500 antitrust actions; over the past year, these groups and also federal courts seem to have developed an even greater appetite for thwarting business combinations. The prolonged overhang of the DOJ's antitrust action waged against Microsoft, plus the initial ruling this past April to break up the company, were significant factors in Microsoft's stock price decline - over one-third in market value from its peak in December 1999. In addition, the federal government's extended, hard-line efforts to quash the WorldCom/Sprint merger dragged down a large number of telecommunication stocks. Nearly every week brings more evidence that the government seems to be pursuing an increasingly less business-friendly agenda, and these concerns cast a pall on a number of industry groups and further contribute to stock declines. Although the federal government will not be able to completely forestall business combinations, it effectively is raising the bar for investors who are considering certain stocks and industry groups that might conceivably benefit from mergers and acquisitions.

The national elections also will influence the markets both directly and indirectly. Current speculations are that George W. Bush is more likely to provide a good or at least reasonably friendly environment for taxpayer and business interests. Recently Vice President Al Gore shifted his campaign to a more populist tone in pillorying "price gouging" by the oil and pharmaceutical industries. With the government's increasing hostility to business combinations and the recent attacks by Gore against key industry groups, most stock investors probably will feel less complacent about a judicial and regulatory store minded by Gore. More generally, the stock market probably will not view the election of Gore as a major positive.

Dancing Toward Prosperity

Over the next several weeks and at least until traders return from their summer vacations, the markets probably will continue their minuet of two steps forward, one step back, one step forward, two steps back. As this nowhere dance continues, an occasional merger or acquisition likely will catapult individual stocks and possibly their industry group. Mercifully, the Summer Olympics will interrupt the drone of the economists' what-ifs. We also will be treated to the political conventions, where we can watch grown men and women wear silly hats as they stake out lofty aims that are memorialized in party platforms soon discarded for the more serious sport of mud-slinging. Seasonal amusements aside, expect that post-Labor Day polls on the elections will have more than a passing effect on investors' actions and portfolios.

Against this background, and with the likelihood that key economic sectors are indeed slowing down, the investment community can expect that interest rates probably have peaked or are due for only one more modest increase before year end. The more intense this conviction, the more the markets might anticipate that a more benign and eventually accommodating Federal Reserve will loosen its monetary purse strings. If the spate of economic statistics that will be doled out over the next several weeks do not sustain the portrait of a somewhat slower economy, then the markets, fearful of Mr. Greenspan getting nervous again, could renew their uncertainty, volatility, and vacillation between euphoria and fear. Although we believe the Federal Reserve is largely done with its tourniquet torture, we would not rule out at the Board's next meeting one more upward twist in rates. We are cautiously optimistic on the outlook for the markets, but would view a too-rapid recovery in technology stocks as premature. Even if the Fed is finished or close to finished this cycle with its role as inflationary policeman, investors may not have completely discounted the impact of a slowing economy that becomes even slower, with potential negative implications for corporate profits. This could especially be the case for resurgent Old Economy stocks might well pause if the Fed's bite draws blood and the flight of capital that recently buttressed these stocks gives way to a concern for profits.

In a word, uncertainty probably will remain the order of the day for the next several weeks and possibly until Labor Day. Conflicting economic signals likely will help maintain the recent quarters' higher volatility by individual stocks and major market indices. Yet, despite the ongoing tug-of-war between the bulls and the bears, numerous opportunities exist for achieving good, long-term returns from the equity markets.

The benefits of technology will continue to permeate both the Old and New Economies, even with the sputtering flameout of numerous high-tech and Internet companies. Many Old Economy companies are incorporating into their business models the best features of the New Economy and thus improving profitability. Many winners likely will emerge from the ashes of the Nasdaq crash of this past spring. As always at KING, our focus on the business valuation of going enterprises should serve our clients well when taking a long view.

In the absence of a clear and consistent market trend, individual stock selection will play a key role in future performance. Our emphasis on investments in media, telecommunications (especially broadband and wireless), and certain areas of the medical industry should capitalize on some of these long-range trends and be far more important than what the Federal Reserve does at its next meeting. Likewise, our investments in special situations should benefit from the continuing imperative of businesses to grow through mergers and acquisitions in order to stay competitive in a world in which the only constant is rapid change.

The dramatic market correction of this past spring has been healthy for the markets and investors. Purging the worst abuses of speculation, an ongoing process, will result in a better allocation of capital to companies that can provide investors with a reasonable rate of return. Despite our wariness of the near-term - specifically its potential for false starts, high risk in the face of company-specific disappointments, and market schizophrenia over the Fed - we are very bullish about the long-term prospects for equity investments. The secular outlook for our domestic economy and global growth, spurred by technological changes of almost revolutionary impact, is quite exciting. Well-chosen investments that capitalize on this growth and the undervaluation of individual companies often overlooked by the Street - these should be rewarding investments indeed. We are eager for the future.

Roger E. King
Chairman and President