Investment Outlook

Despite the near-term problems posed by the Middle East, fundamentals are judged to be positive for a good number of quality stocks.

The terrorist attack on the U.S. destroyer Cole and a flare-up in Middle East tensions sent crude oil prices to $37 a barrel last Thursday, propelling the Nasdaq Composite to an 11-month low. Before rebounding on Friday, the DJIA flirted with 10000 for the first time since March. Nasdaq got close to the 3000 level, where it was off 39% from its March high of 5049. Fridays big rebound, on declining oil prices and some cooling off in Israel and Palestine, suggests that the bargain-basement levels of some stocks have the potential to turn the market positive provided an oil crisis is averted. In late May, of course, Nasdaq enjoyed a similar bounce (up 19% in a week, 27% in three weeks) before succumbing to worries about earnings and valuations during the summer. Over the summer, investors ran into resistance levels around Nasdaq 4200; in October, a market floor of Nasdaq 3000 has so far held up to selling pressures verging on a secular bear market for many stocks.

The obvious temptation is to look for parallels with 1990, the last time an oil price shock pitched the U.S. economy into recession. There are indeed troubling similarities between 1990 and 2000: oil prices up in the $35-$40 range; hostilities in close proximity to Arab oil fields; a slowing U.S. economy; and a real federal funds rate in the vicinity of 4%. Consumer confidence and spending are being impacted by the headlines, although so far at least the effects have been much shallower than in 1990. In fact, last weeks retail sales report was a fairly strong one, with sales running nearly 8% above year-ago levels, twice the growth rate seen at a similar point in 1990 (and more than that in real terms). Shares of retailers have been among this years worst performers, a marked contrast to their relative strength in 1990-91. Tech stocks lagged coming out of the economic slowdown of ten years ago, a pattern that may be causing investor anxieties currently. Financial stocks generally did well in 1991-93, but we dont appear to have room for the same sort of interest rate declines (200 basis points at the long end of the yield curve and more than 300 at the short end) today.

But are high oil prices the real problem bothering investors? Is 1990 the appropriate model for today? For all the parallels between 1990 and 2000, there are also dissimilarities, the most relevant being that oil is only about half as important to the economy today as it was then (spending on technology is correspondingly higher). Equally significant, the core inflation rate in 2000 is running well under its 4%-plus rate of 1990. Sure, it is possible that oil and the Middle East will escalate into even bigger problems for the economy and markets. But a more likely course would appear to be a subsidence of tensions and oil price pressures, allowing investors to turn their focus back to more positive thoughts such as productivity improvements and budget surpluses, say. It is certainly in no ones interest to plunge the world into another economic crisis.

Equities possess many fundamental strengths today, strengths which ought to produce positive returns going forward. Aside from higher levels of corporate profitability, growth and productivity, stocks should also be boosted by low inflation, growing budget surpluses around the world, and demographics favoring savings and investment. Each of these long-term pluses could be diminished in the short term by recession, although probably not for long. The upsurge in global competition that began with the fall of the Berlin Wall in 1989 has yet to reach its full expression, no doubt a worry for some firms but a net plus for innovation and advance in the free markets of the world.

Still, playing devils advocate, one also notes similarities in the current market with 1973-74. For all the fundamental strengths in the economy and corporate profits in 2000, there are a number of unfortunate parallels with the recession/bear market of 1973-74 the Yom Kippur war, the OPEC oil embargo, and economic slowdown (which developed into the worst recession in decades). The early 1970s even had its own version of todays new economy/old economy split in the so-called two-tier market of those years. To read a list of the famous-name growth stocks of 30 years ago (stocks like Black & Decker, 3M, Xerox, K-Mart, Burroughs, Sears, McDonalds and Texas Instruments) is to understand the process of creative destruction that has reinvigorated U.S. industry and the U.S. economy in recent years but at a steep cost to companies that failed to adapt.

INVESTMENT OUTLOOK . . . While the boldest, most outlandish new-era predictions of a year ago have already been discredited, in the long run technology still trumps oil. That doesnt mean the energy stocks will all merge into one giant ExxonMobilChevronTexaco or that all tech companies should get carte blanche treatment. But it does mean that some of the oil stocks may be getting pricey, and some of the dot-coms and Internet infrastructure firms with viable business plans and legitimate prospects for profits are getting attractive. Whats more, contrary to 1973-74, one has to be encouraged by the way the broad market has stood up to the pasting that the techs and the telecom stocks have endured in 2000.