The Tale of Two Indices        Jan.  2001 - Issue 4

One year ago, we re-stated our concerns in respect of the US equity market bubble, particularly within the technology arena.

We were being told by the herd that 'It is different this time,' the economic cycle had been transformed and that equity market valuations were justified in a low inflation environment.

For those prepared to look, evidence was at hand suggesting that indeed a mania of mega proportions had developed. History is littered with similar periods of 'irrational exuberance' and, inevitably, the boom is followed by bust. 

As can be seen in the chart above, bust came to the technology rich Nasdaq in early March of last year. Over the year it fell by 39%, or by a huge 50%, since the March highs! 

We had noticed an uncanny resemblance to the shape of Japan's Nikkei during the boom and subsequent bust of the late 1980's/early90's. (see Issue 1 newsletter). 

The expected 2300 Nasdaq level was reached on day one of the new trading year - but Investors have yet to panic. The herd, of course, are now recognising that there was indeed an internet bubble that burst last Spring. They are to be applauded for the 20/20 hindsight but are still missing the point. The bubble was not only the internet stocks but the entire Nasdaq, and to a slightly lesser extent, the S&P 500; the Dow Jones Industrial Average and the mighty US Dollar.

It is interesting to note from the above chart, that as the Nasdaq started its' fall, the S&P 500 rose strongly as investors rotated into what they considered as quality, aided and abetted by a stronger dollar as overseas flows continued to buy the 'bargains' available. This enabled the S&P to hold onto the minimal early year gains until early September since when it has followed the Nasdaq lower, producing a 10% loss over the calendar year and a 13% loss from the early September level achieved. So what now of valuations? Is the Bear market over and can we return to Blue Sky investing?  Hardly!

Historically, busts end with an aura of fear, with P/E ratios trading at half of their normal trading range. Nasdaq enthusiasts tell us that a normal P/E is the 25-30 range. Well, having reached a ridiculous 245x in early March (did your fund manager report that to you?) the Index has now fallen to….. only 80x. A little way to fall yet we fear.

The S&P500 represents 85% of the American stock market and ended December 2000 at 1328, the same level as it ended July 1999. Over this period, equity mutual funds received a net inflow of a near $500 billion. How will it fair as the inflows not only recede but also become an outflow?

From early 1999 to March 2000, the technology sector increased from 19% to 33% of the S&P500 Index, since when the technology collapse has reduced this weighting to approximately 22%. This is still a significant weighting.

As we complete the first trading week of the New Year, the financial markets have continued from where they ended last year, confusing to most, and with high volatility.

After a first day fall of 7% by Nasdaq, an extraordinary intervention by the Federal Reserve saw US interest rates cut by 0.5% to 6%, followed by a further 0.25% cut in the discount rate on the following day. The initial euphoria saw the broader equity market up by 5% on the day, with the Nasdaq index up a mighty 14%, its largest one-day advance in history. However, by the end of the shortened trading week, these gains had been lost, and then some.

The nature of Bear markets is that the direction is down, interspersed with short, sharp rallies. These rallies are made to separate the largest amount of money possible from the majority of investors. We do not expect to be amongst this majority!

We do not wish to shout "fire" in a crowded theatre but we have to be realists in the scenario as we see it. Our analysis; timing models; and a healthy respect for history, will bode well for our investment strategy throughout 2001 and for the clients who receive it.