"The four most expensive words in the English language are this time it's different."

After suffering through significant declines in the equity markets over the course of 2000, especially in the tech-laden Nasdaq, investors hoped for a new beginning and an accommodating Central Bank as the curtain rose on 2001. The equity markets received a New Year's gift from Alan Greenspan on January 3rd in the form of a surprise 50 basis point interest rate cut. The announcement sparked a record 14.2% rise in the Nasdaq, the largest one-day gain in both percentage and point terms since the index was created in 1971. The so-called "January Effect" was particularly strong this year as many tech issues that had suffered massive price declines and were victims of tax-loss selling pressure at year-end bounced back strongly. The major equity indices registered gains for the month of January, with the Nasdaq posting the largest increase of 12%, as investors hoped that Greenspan's commitment to engineer a soft landing signified by his inter-meeting rate cut would lessen the chance of a protracted downturn and lead to a healthier equity market.

On January 31, the Federal Reserve cut the Fed Funds rate by an additional 50 basis points to 5.5% and maintained its bias to focus on economic weakness. The aggressive yet expected action by the Fed was the second rate move in less than a month; the 1% decrease fully reversed the rate hikes that occurred during the year 2000. In his testimony before the Senate, Greenspan reversed his previous position and acknowledged the viability of tax cuts as an effective fiscal policy instrument given the size of the projected budget surplus. Greenspan's position significantly increased the likelihood that a tax cut package would be enacted, as those who opposed tax cuts lost a major ally.

After a brief period of positive gains during the month of January, the major indices have taken a beating of late as earnings concerns and worries about continued economic woes have outweighed the optimism stemming from the interest rate cuts of the Federal Reserve. On March 20, the Fed cut interest rates by 50 basis points for the third time since the beginning of the year. The market sold off after the news as many investors were hoping for a 75 basis point cut (some even hoped for an unrealistic move of a full percentage point). Some recent economic data hinted that a half percentage point was appropriate. Auto, home, and retail sales have held up surprisingly well; these positives coupled with the relative strength in the labor market and the slowing decline in consumer confidence suggest that the economy is weak but not necessarily in as bad a shape as the doomsayers would have us believe. While overall economic data continues to be mixed, it is clear that there are several serious issues in some segments of the economy, such as in manufacturing and technology. And while unemployment has not picked up dramatically, large layoffs recently announced by a variety of companies- from large-cap companies such as Motorola, Morgan Stanley Dean Witter, Citibank, and Lucent, down through the ranks of the imploded dot-com companies-have yet to fully hit the books.

The Fed's decision to not act earlier during the economic slowdown has cost equity investors dearly. And as a record number of corporate warnings have ushered in the second quarter, it seems as though the Fed was still behind the curve as the second quarter began. While corporate earnings disappointments are expected at this juncture, the surprise and the troubling element is the magnitude of these warnings, not just the quantity. Greenspan and company have been responding to some degree to this weakness. After all, with its third half-point cut in three months, the Fed had virtually undone the entire last round of rate increases that took a full year to implement. To put things in a historical context, when the Federal Reserve started easing at the beginning of the last recession in 1990, six months had passed before it had cut rates by as much, and it was not cutting this rapidly until late 1991, more than a year after the downturn had started.

However, it appears that throughout the fall of 2000 and the spring of 2001, the Fed was looking at a different set of tea leaves than the rest of us, a set which did not reflect the true level of economic deterioration which thus far has occurred. While Greenspan has been criticized in past years for focusing on the level of the stock market during his infamous "irrational exuberance" speeches in the late 1990s, he cannot ignore what has occurred over the past year in the equity markets. The Fed's job has always been to shepherd economic growth to an appropriate level and to keep inflation in check. As such, it must remain an independent, autonomous body, and it would be dangerous for the Central Bank to give the impression that the Nasdaq is dictating its policy. Nevertheless, the economic effect of the wealth destruction caused by the precipitous decline in the equity markets must be registering on the Fed's economic barometers.

With that said, as the second quarter begins, we anticipate that the Fed will become much more aggressive in order to add a much needed liquidity shot into the system. Greenspan recently made it clear that the Fed stands ready to aggressively lower rates further should the "need" arise. In its last statement after the rate cut of March 20, the Fed pledged to "monitor developments closely," a phrase that it used shortly before its inter-meeting rate cut of January 3.

What went wrong?

It took two years for the Nasdaq to climb from 2000 to 5000 and it took less than a year for the return trip. To put things into perspective, in one year Cisco, Microsoft, Intel, Lucent, and Oracle lost over $1 trillion in market value-an amount equal to the value of the entire stock market in 1980. While interest rates themselves have played a role in the movement of the equity markets, a major reason for the rapid ascent and the recent demise of the Nasdaq is the Fed's manipulation of the monetary base over the last couple of years. It is very important to remember that while the Fed does not have complete control over interest rates, it does have virtually 100% control over the U.S. money supply. Comparing the performance of the Nasdaq against the growth of the monetary base, it is uncanny to see the impact the latter has had on the former. Starting in late 1999, in preparation for Y2K, the Fed pumped up the monetary base. This stimulus lasted through early 2000. The rate of growth of the money supply came close to an astonishing 50%. When Y2K turned out to be a non-event, the Fed had a problem. Its fix was to mop up the excess liquidity as fast as possible. As a result, we essentially went from excessive growth to negative growth in the monetary base. This change caused a severe problem for certain sectors of the equity market, including technology, telecommunications, and small-cap biotechnology, as their access to capital began to evaporate.

The performance of the Nasdaq leaves no doubt about the cause of the tech-stock bubble and the cause of today's deep slide in stock prices. Since the mop up operation, the Fed has managed to get liquidity back under control, and the monetary base is now growing at a reasonable rate. A major problem, however, is that the Fed is way behind on making this correction. For the investment world to regain its footing, banks must again start lending and credit spreads must start to narrow. The last three Fed easings did nothing to ease credit spreads because the financial market feels that the Fed did not do enough and the risks of further economic deterioration are heightened. This trend is very market unfriendly and the further widening of credit costs suggests that capital is too selective and is not re-engaging the economy. In order to reverse this situation, the Fed must cut interest rates more aggressively and pump money into the system in order for companies to be able to properly implement their growth plans, for consumers to regain their confidence, and for the equity markets to begin to reverse their recent losses.

Since their peaks in the late 1990s/early 2000, stocks of companies of all stripes and sizes have suffered dramatically in the recent downdraft. By the time the first quarter of 2001 drew to a close, the median company P/E in the S&P 500 index had contracted 27% to 17x, versus a 55% median decline to 35x for the tech-heavy Nasdaq 100, and a 31% decline to 18x for the median Dow industrial stock. Although the general media has emphasized the dramatic fall of the Nasdaq over the last year, what is interesting to consider is the period the declines began for each of these indices. For the broader market, this process began in early 1998. In fact, as of late, many individual non-tech stocks have begun to actually advance as evidenced by the recent improvement in the advance/decline line. The correction process also began earlier for the Dow, which topped out in late 1998. For the Nasdaq 100, the process started much later, in late 1999, but was much more violent. However, at a median multiple of 35x, many Nasdaq stocks are still relatively expensive, especially in light of either no growth or a decline in year-over-year earnings projected in 2001 for many. Take Cisco; despite a 59.3% decline through the end of the first quarter, the stock still traded at a hefty multiple of 27.8x 2001 earnings estimates. The same could be said for Sun Microsystems (down 44.8%, yet still traded at 31.4x) and Texas Instruments (which declined 34.1% and still traded at a lofty 40.9x 2001 estimates).

We have mentioned the damage to the Nasdaq, where the rise and fall was most dramatic. However, the severe price declines have not been limited to this index. The following "low risk" stocks have either suspended/reduced dividends or have suffered major price reductions in the past couple of years-Edison International, AT&T, Xerox, Lucent, General Motors, and J.C. Penney. In fact, over the past twelve months, ten of the 50 largest-capitalization stocks traded in the U.S. lost 20% of their value in a single day, almost 11 times the historic average.

After the recent broad sell-off, no sector or industry has been left untouched. The following statistic is a mark of how widespread the difficulties have become: as of March 30, only 193 of the stocks in the S&P 500 had gained ground in 2001, while 307 were down. The average stock in the market-weighted S&P has fallen 7.4% through March 30, 2001, while the average S&P stock rose 11.2% in 2000 even as the index fell 10% (the index was pulled down by big technology stocks that fell more sharply than the rest of the market). The week ended March 23 was significant in that it marked the eighth consecutive week the S&P had fallen, a string unmatched since 1970. The level of selling intensified on March 22 as initial signs of capitulation appeared--the NYSE posted its third-highest volume session of 1.7 billion shares, while 2.5 billion shares changed hands on the Nasdaq, its fourteenth busiest day ever. Negative sentiment is ubiquitous. As of April 3, The Market Vane indicator, which measures the advice given by professional investment advisors, showed that only 18% were bullish on S&P futures, an unusually low level of bullishness. All of these measures point towards capitulation and signal that perhaps the peak in selling may have been realized during March and April. There is a tremendous amount of cash on the sidelines. We are probably in the process of forming a bottom in many stocks.

So stocks must be a good buy now?

While it does look like many stocks are trying to find a bottom, or are in fact starting to advance, we are not of the opinion that the equity markets will recover in a "V-shaped" pattern or that all stocks are poised for a rebound. For example, many large-cap tech stocks may not begin a sustained rise for a prolonged period. A point one cannot overlook is that despite the declines in many of the large-cap tech stocks, insider buying has not emerged. In fact, many corporate insiders are still fairly bearish. This is the exact opposite of what one would expect in this market. Insiders, supposedly the people most highly attuned to their companies' outlooks and operating environments, certainly had fortuitous timing last year. As a group, negative insider sentiment spiked in February 2000 and again in August 2000, in both cases just before the market took a dramatic turn for the worse. Little has changed since last year, despite the declines in stock prices. One way to gauge insider sentiment is to look at how many dollars worth of their own company's shares insiders sell for every dollar they buy. According to Lancer Analytics, the sell-to-buy ratio in February 2001 was 29:1, the highest, or most bearish since the firm began tracking the data in 1996. In January 2001, the ratio was 25:1, twice the average since 1996, and up sharply from December's 10:1 figure. To look at some specific examples, despite a 59.3% decline in Cisco's price during the first quarter of 2001, no insider buying had emerged. In fact, in March alone, insiders filed to sell a total of 338,454 shares of stock.

By contrast, insiders in some non-tech, more reasonably valued companies like Boston Scientific, Energizer Holdings, and Federal Signal began buying shares in their companies back in the summer of 2000, after their shares had retreated. Importantly, virtually no insider selling is occurred in many of these non-tech companies. In addition to insider buying, one can also look at the composition of those companies which had announced major share repurchases over the last few months. Philip Morris, AT&T, Boeing, and Ford have all recently announced share buybacks exceeding $5 billion each. In addition, several companies, including Conoco, Ultramar Diamond Shamrock, Oxford Health, and Continental Airlines, recently announced their intent to buy in 20% or more of their outstanding public capitalization. This type of activity indicates that many old economy managers are increasingly comfortable with their companies' near-term recovery prospects. Again, we have yet to see this sort of positive activity in the high-tech sector, leading us to believe that many insiders feel that a turnaround is not imminent.

The use of margin debt seems to be waning; a positive sign?

With the stellar returns seen during 1998 through early 2000, many investors were caught up in the excitement of the prospect of "easy money," and the use of margin debt to acquire stocks rose dramatically. The ability to leverage one's existing finances into potential riches led to temptation and the eventual onset of the day trading phenomenon. Today, margin debt has decreased significantly. Both margin balances and margin calls peaked in December 2000 and are now down 30% and more than 50%, respectively, from those peak levels. The last sharp increase in margin calls occurred in February 2001. In many ways, the last part of 2000 and the spring of 2001 sparked the same painful pattern that was seen last year at this time. At Fidelity Investments, management recently stated that "the average size of margin calls has been significantly less that it was at this time last year", and that the average margin debit balance is down approximately 60%. The significance here is that the snowball effect of market declines has been tempered as less forced selling has been occurring to meet margin calls, a direct result of the decline in the use of margin. This too helps pave the way for an eventual bottom and consequent advance.

Over the past year, the average individual investor was not the only one caught up in the buying frenzy and the lure of quick riches. Members of management teams of many companies, especially in the technology and telecom industries, were also swept up in the wave of greed. In a proxy statement filed in late March 2001, one Internet-service provider reported that it had lent its CEO and three other executives a total of $4.55 million to meet margin calls on shares of its company's stock. This scenario certainly is not limited to the high tech sector. A similar situation also occurred at a large telecom company, as its CEO received a margin call and was forced to liquidate three million shares onto the open market. Much of this shakeout from margin-related selling has probably already impacted share prices. As a result, while we could see further selling, it is less likely to be compounded by the artificial selling that the use of margin creates. Many investors learned a very painful and expensive lesson over the last several months about how the use of margin can adversely affect one's personal net worth in an expedited manner. A positive lesson from this experience is that many investors are more likely to be more disciplined going forward, as much of the excessive behavior which generated the frothiness seen in the equity markets over the last year has been tempered or eliminated.

Has the pain subsided?

Today it is obvious that an extreme peak in the equity markets was reached in March 2000, a mania which culminated in an absolute collapse and the destruction of $5.3 trillion in market cap, a value which is equal to half the U.S. gross domestic product. However, it is important to note that the markets frequently tend to act in an extreme manner, both on the upside and on the downside. While we were in a position of being extremely overbought last year at this time, this spring brings us a period where many stocks are in fact very oversold. (insert weekly excel chart). As evidenced by the accompanying graphs, we now seem to be close to a bottom. While the pain has been extreme in many areas, several factors are lining up which cause us to be optimistic about the future. For one, history is on our side; excluding the 1929 crash, the S&P 500 has risen 55% on average from the bear market troughs to new highs which were typically reached 22 months after the bottom. Specifically, this applied in 1974, 1982, 1987, and 1990. However, with that said, the recovery this time won't fully occur before the economy perks up, visibility on corporate earnings improves, corporate bond spreads narrow, the capital markets re-open, and consumer and corporate confidence recover. In addition, many high P/E stocks have endured significant damage, and, in fact, are not great values, despite their massive declines in market value. The bottom line is that many stocks with high valuations may continue to languish for quite some time, and many second- and third-tier players will not come back at all. Corporate bankruptcies and restructurings are likely to continue throughout 2001 among these sub-tier players.

We believe that the adherence to our Business Valuation Approach will continue to uncover attractive investment ideas in any market or economic environment, and that our clients will profit over the next few years as a result. A question we have been asked of late is how our emphasis on private-market value will do in a market environment where mergers and acquisitions may slow. Importantly, M&A activity does not have to occur for our approach to succeed. We have often stressed that M&A activity is a byproduct of our approach. The analysis of companies utilizing private-market value often uncovers overlooked companies which have attractive franchises, assets, or strong cash flows. Regardless of the existence of industry consolidation, the value inherent in these companies is usually unlocked over time as the market eventually begins to overlook whatever transitory event caused the stocks to become cheap in the first place.

The primary reason KING's clients have historically seen a lot of takeovers in companies we own is that often the market is very short-term oriented, while a company's competitors and other strategic buyers are more long-term oriented. As a result, when a company stubs its toe and falls out of favor, the market is frequently inefficient over the short-term and focuses primarily on the current problem, as opposed to focusing on the true inherent value embedded in the company. On the other hand, a competitor or strategic investor/buyer can often overlook the temporary problems and determine how value can be unlocked in their hands through cost cutting efforts and other synergies. As a result, another company can capitalize on a temporary stock price decline and acquire an out-of-favor company, paying a nice premium to where the stock was trading in the public market, yet at a price they consider a very attractive valuation over the long-run. However, this type of activity merely provides an acceleration to the realization of a company's true worth. Absent an acquisition, since the market is fairly efficient over longer periods of time, a company's hidden value will eventually be recognized, and patient shareholders will be rewarded. Thus, the strategy succeeds in all types of market environments. However, acquisitions at a healthy premium are always a nice benefit for clients, but we consider this a welcomed by-product; it is not something on which we rely on in order for our approach to succeed.

With that said, despite the liquidity issues present in technology, telecommunications, and other industries, companies in other sectors of the economy, such as energy, healthcare, and select players in the financial community, have very strong balance sheets and have the currency to engage in M&A activity. Evidence of this lies in Tyco's pending acquisition of CIT Group, the bidding war for American General Corp, and Johnson & Johnson's pending acquisition of Alza. In health care in particular we could see an acceleration in M&A. As many large-cap, global pharmaceutical companies face the prospect of losing patent protection on many major blockbuster products, they are searching for other growth avenues. Essentially, they are seeking to buy growth. An attractive solution is available in the specialty pharmaceutical area as many companies have pipelines which are targeting cures and treatments for diseases such as Alzheimer's, Crohn's Disease, heart failure, and stroke-areas which involve innovative products that should command very healthy margins when eventually introduced onto the market. Potential takeover candidates in this area include King Pharmaceuticals and Elan Corp. Eventually we should also see consolidation in the generic drug industry where mass and scope are critical. It is also an area where the regulatory, political, and legal environments are becoming less hostile than in the previous presidential administration. Candidates for consolidation include Watson Pharmaceuticals, Alpharma, and Mylan Labs. Also, the prospect for a pick-up in M&A activity exists in the medical device area as leaner operators look to acquire more cumbersome competitors, companies which may have improving pipelines but could benefit from improved efficiency and operations. Boston Scientific is such an example.

Finally, despite the pullback in valuations in telecommunications, M&A should continue in the wireless area, as providers must have spectrum in order to expand their footprints and meet the demand of customers. The acquisition or purchase of spectrum is a primary vehicle for companies to survive and compete in today's highly competitive environment. With that in mind, Dobson Communications, Western Wireless, and Rural Cellular all possess assets which cannot be easily replicated and have values which should eventually be recognized in one way or another by the market or strategic buyers.

Where do we go from here?

While it does not seem like it, bear markets do not go on forever. In fact, during times when everything seems very bleak and dim, the worst is frequently already over. It is when optimism is high and conditions seem perfect-much like in the winter of 1999 and the spring of 2000-that the markets can be blindsided and come crashing violently down. Today, the headlines are filled with news of layoffs, corporate warnings about analysts' estimates for the quarter being too high, weak economic conditions, global turmoil, and concerns about too much supply. In other words, the bad news is out there and has already been discounted by the market and investors. Another contrarian indicator is the record high level of pessimism as measured by the put/call volume ratio in the S&P 500. (insert put/call graph) Historically, this has often been a precursor of a significant market advance (especially when this ratio breaks 1.0).

The Bush administration's proposed tax cut could provide a boost to market valuation in the near-term, and the Bush team's pro-business and deregulatory ideology should help pave the way for recovery, as these beliefs reverse former government policy which may have contributed to a souring of the mood toward equities. A more accommodating Fed and a positive, albeit less than ideal, tax reduction package, should provide some of the elixir the market needs to recover its strength. Today the economy is in a favorable position in that excess capacity exists, thus demand can be stimulated without excessive fear of an acceleration in inflation. Energy costs will not be escalating at the same rate in future months, and may even decline. Further, strong messages from the Bank of Japan (0% interest rates and quantitative easing) coupled with increased signs that the manufacturing inventory correction is near an end should stabilize markets; it is just a matter of time until this flows through the economy.

Those who maintain that the market will drop further because the S&P's P/E is above the historical average forget that inflation is lower today. A low-inflation environment merits a higher P/E because it produces lower interest rates. Lower interest rates make it easier for companies to finance their operations, raise the present value of future profits, and make equity investments relatively more attractive than fixed income instruments. Although the near term outlook for economic growth and corporate profits is not promising for equity investors, (in fact, a profits recession-two consecutive quarters of negative year-over-year growth-is quite likely in the first half of 2001), the current inventory glut will be worked through over the next few months and economic growth will begin to incrementally accelerate; the stock market usually begins to rise about six months before the beginning of an economic recovery. The last four times the Fed has cut interest rates three times, the market has been appreciably higher twelve months after the third cut. Disciplined investors with time horizons longer than a few quarters should be rewarded.

Leah Friday, CFA
Ryan McCleary

Other contributors to this issue:
Roger King and Marcey Whitney