What Now?

By most traditional measures, the US stock market is back to or above the levels that prevailed on September 10^th, before the terrorist attacks on the United States. Thus, on November 9^th,

· The Dow Jones Industrial Average closed just above its September 10^th close of 9605, and up 21% from its September 21^st low.

· The S&P 500 Index also closed above its pre-attack close and up 18.5% from its September low.

· The NASDAQ Composite closed at almost 8% above its September 10^th close and up 31.8% from its September low.

All in all, therefore, the positive comments of our September 17^th Headlines & Bottom Line were timely -- at least from a market point of view. (See: Pushing on A String… Or A Spring?) This seems like a good moment to review our investment assumptions in the light of subsequent events.

In times of economic, financial and political upheaval, current economic statistics mean little, since they are distorted by those very events. It is therefore best to fall back on plain common sense to evaluate the situation.

Is The World The Same As On September 10^th?

In a nutshell: no. After history-changing events, investors often succumb to one of two misguided tendencies. The first is to assume that the world is back to normal; the other is to speculate that all has been radically changed forever. Both assumptions are usually wrong.

Many things have changed since September 11^th. The United States is at war, though a new kind of war. Given the diversity and fuzziness of the enemies, it promises to be a long affair, with both destabilizing and mobilizing effects. For example, it is not only an American war. Many other countries have to deal with one kind or another of terrorism. With the building of the western coalition, most forms of local unrest have been exacerbated, while governments’ determination to deal with them has been reinforced -- sometimes very opportunistically. America’s ability to restrain human rights violations by allied governments and to promote Western-style democracy has thus been weakened. (See: A Multidimensional Puzzle)

Domestically, too, both consumption and investment patterns will be durably altered, as will fiscal priorities and trade/investment flows. This will not necessarily mean the absence of growth, but the drivers of that growth will likely be different – in a way that will only become fully apparent later.

Has The Economic Cycle Changed?

Except for secular backdrops that taint them differently, traditional economic cycles are deeply rooted in human and crowd psychologies that change little over time, always fluctuating between excesses of enthusiasm and pessimism. There is little reason, therefore to believe that economic cycles have been durably altered.

The present cycle, however, will have been sharply accentuated by the events of September 11^th and their aftermath. Furthermore, it is likely that the change from the boom environment of the 1990s to a more subdued, “digestive” period (which had already been shaping up) will also have been accelerated.

The terrorist attacks took place just as the United States was falling into recession. The initial blow to consumer and business confidence precipitated the process, while the accompanying economic disruptions worsened it. The United States was suddenly running the risk of a much sharper and deeper downturn than had been anticipated. The aggravation of America’s outlook also carried dour implications for the rest of the world economies, most of which had relied on the US boom to fight recessionary forces at home. As a result, the chances of the world economy falling into recession in sync were significantly increased.

Fortunately, the policy response, first from the United States and then from other countries, has been both decisive and massive. Money supplies have exploded around the world and now, fiscal stimulus is being implemented in many countries, which will give traction to the new liquidity injections.

As a result, a V-shaped view of this cycle has been given credence, with a much deeper, but shortened downturn to be followed by a sharper recovery than would otherwise have been feasible. At the moment, of course, we see mostly massive inventory reductions and layoffs, but these aggressive “liquidations” all but guarantee a strong bounce, once they have run their course.

What Happens After The Bounce?

Unfortunately, even with plenty of liquidity infused by the Fed and a great deal of fiscal stimulus, the US economy is unlikely to soon experience the kind of extended boom environment it enjoyed in the 1990s. One reason is that most pent-up consumer demand has been satisfied – often thanks to significantly increased borrowing. In addition, over-investment is several sectors of the economy in anticipation of unrealistic rates of growth has left large amounts of unused capacity – especially in telecommunication and high-tech industries – that will weigh on both profit margins and capital spending for a while. Some observers also believe that the huge amounts of mortgage refinancings that accompanied declining interest rates in recent years have not only artificially boosted consumption, but also produced the equivalent of a bubble in some housing. In other words, growth in coming years will not only be on a slower trend than in the 1990s, but it will also be more cyclical – as it was in the past.

Elsewhere in the world, however, economies are not as overextended, since most have been fighting either recession or stagflation for several years. Many also have more development potential than exists in the United States. Often, domestic attitudes have been less shaken by the events of September 11^th than in the United States: given the right economic environment, consumers will consume and businessmen invest. True, many of these countries are still struggling with shaky financial systems – both in Asia and Latin America. But they should be helped by the fact that the long-awaited weakness of the US dollar should start materializing.

The apparent invincibility of the US economy has evaporated with the bursting of the tech bubble; the spectacular productivity gains of the 1990s are being questioned; projected fiscal surpluses are evaporating; and the dollar seems overvalued against many other currencies. More importantly, investment opportunities in the American economy now seem less attractive than in recent years – or at least less urgent. International capital flows, which had overwhelmingly favored the dollar until this year, were giving signs of reversing even before September 11^th and more of the huge amounts of liquidity being created by central banks should soon start flowing to other economies. This will help investment in Asian and Latin American emerging economies and, since many of these countries have attempted to manage their currencies in relation to the dollar, their products should also become cheaper in recovering markets outside of the United States.

In addition, domestic demand in many foreign economies, particularly developing ones, has shown great resiliency, even in recent hard times – whether this is captured by inadequate statistical tools or not. Better investment flows, and trade gains with Europe and Japan, should boost consumption further.

Our view is that foreign economies may well be slower to bounce than that of the United States, but that their recoveries will be more sustainable and, eventually, stronger. Thus, at some point, probably in the next eighteen months, we could well witness a synchronized upswing of the global economy, even with a more subdued American performance. This would be good for everyone, but especially so for traditional industries that have struggled with global overcapacity for much of the last decade – commodities and industrial materials in particular.

Are Stocks Cheap?

One of the main problems for investors is that no sustained advance in US stock prices has ever started from the kind of price/earnings ratio levels prevailing today. The S&P 500 Index fell 38% from the spring of 2000 to the lows of September 2001. Even with the subsequent recovery, it is down 27% from last year’s highs. Yet, its P/E ratio on 2002 recovery estimates, remains above 20x.

Incidentally, in view of the devastating decline of the NASDAQ Composite Index over the past eighteen months, and the unusually depressed state of many tech companies’ earnings, we asked one of our interns to compare the price-to-sales ratio of a few leading tech companies to those that prevailed before the 1997-2000 stock market tech bubble. Sales are less volatile than earnings and this ratio thus constitutes a better comparison. Well, tech companies’ price-to-sales ratios, while down substantially, remain well above anything that prevailed before the bubble – when long-term growth trends were easier to extrapolate (or imagine) than now and tech companies were assumed to be non-cyclical. This explains why, despite our considerable research effort, we have only been able to buy a few names in that sector. In any case, if history is any guide, the leaders of the next stock market advance will not be those of the previous one.

If there are values in today’s stock market, they are to be found in traditional industries that struggled in a deflationary environment throughout most of the 1990s and have emerged lean and mean from that struggle. For those, while their P/E ratios may not seem cheap, estimates of profit growth may have become excessively modest, reflecting assumptions that extrapolate the environment of the last decade rather than the emerging one. This new environment will be characterized, we think, by better-shared global growth and less deflation – possibly even some inflation. As our partner Robert Kleinschmidt is fond of repeating, inflation is a monetary phenomenon and, from that point of view, the inflationary process has already started. Furthermore, James Grant (of Grant’s Interest Rate Observer) also reminds us that any war is inflationary, since money is spent on goods that either will not be used for economic purposes or will be destroyed. For many companies in traditional industries, less-volatile valuation measures like the price-to-sales ratio remain modest, and any favorable surprise on the margin front will likely be rewarded by higher stock prices.

In Europe, the situation is broadly similar to that in the United States, though policies seem less decisive. In Japan, forceful restructuring measures being implemented at the corporate level (if not yet at the macro-economic one) promise much higher levels of future profitability, thus leaving room for major earnings surprises and substantial stock appreciation. As for emerging markets, Asian ones in particular, they resemble a massive fire sale, which mixes troubled companies with veritable gems sporting overly liquid balance sheets at once-in-a-lifetime low prices. All this confirms our view that, on the next economic upswing, more money will be made in foreign stock markets than in American ones.

Like The Late 1960s and Early Seventies?

While we do not belong to the camp that anticipates a further, sharp and extended decline in stock prices, we believe that time has to pass before conditions for a sustainable, multi-year advance are met. In the past, we repeatedly claimed that the last years of the 1990s bull market reminded us of the speculative phases of the late 1960s. Now, we believe that the next several years may also resemble the period from the mid-1960s to the late 1970s. During 1965-1978, the S&P 500 remained essentially flat while its earnings, playing catch up, more than doubled. As a result, the index’s P/E ratio declined from 17.6x to 8.3, creating the pre-conditions for the great bull market of the last two decades.

In 1965-1978, the S&P 500 reached as high as 121 (in 1973) and as low as 61 (in 1974). But, for most of these thirteen years, it fluctuated between 80 and 110! Still, this does not mean that investors could not make money: actually, we remember this period as a fairly fruitful one.

One thing that seems almost certain, with shorter and milder cycles around a flattish trend, is that momentum investing – one of the great fads of the 1990s – is dead. For the rest, we have never believed that growth investing and value investing were necessarily contradictory. Indeed, we prefer to invest in growth companies, but not when everyone recognizes them as such and that esteem is reflected in the stock price.

Over the next few years, the naï enthusiasm of investing herds for tech companies will turn into excessive disillusion as stock prices stagnate even as earnings progress. As a result, we believe that the shares of great tech companies will become available at prices that fully satisfy our value criteria. These prices may not be much lower than today’s, but we don’t think that they will be much higher either. The reason will be the inevitable shrinkage of P/E ratios, which may well be worsened by a rise in bond yields if our global economic scenario unfolds. (Rising bond yields usually cause P/E ratios to fall).

Meanwhile, we will concentrate on traditional industrial shares and specials situations, where we find the best values today. We will be somewhat stricter about value than in the recent past, especially in taking profits when stocks rise too much, too fast – as may have been the case recently. But the main change we expect is that our core portfolio will include more shares of great foreign companies, when they sell at compelling valuations while benefiting from potentially much stronger underlying growth trends..

November 10^th, 2001

^© Tocqueville Asset Management L.P.