My favourite ad on TV at the moment is the day trader in braces who is trading on line from home before ending it all by jumping out of his (ground floor) window. If you love volatility, 2000 has been great fun. Even more fun than 1999 when things were arguably less interesting where it was a case of buy technology and telecommunications stocks, or every Internet float you could get your hands on, and just watch it all go up.
No, 2000 has been a much more interesting (read: volatile) year. For me, 2000 has confirmed my faith in two long-held beliefs. First, that even in volatile times, or times of market correction, equity markets are much more discerning than investors give them credit for. Second, at the end of the day, boring things like earnings, business plans, barriers to entry, and even monetary policy do matter: that economic and market fundamentals do reassert themselves.
For an economist and ex-central banker, the particularly nice thing about 2000 is that it puts to rest the notion that higher rates mean nothing to technology and Internet stocks. If anything, higher interest rates meant much more to the highly speculative end of the dot-com market than other companies because the fuel that kept their share prices powering ahead – liquidity – was being dried-up as a result of the US Federal Reserve’s monetary tightening cycle.
While the first half of 2000 has been interesting – the rise and rise, collapse, and rise again of the NASDAQ has been the obvious highlight – where to from here?
The rest of this column explores the key issues that will determine the performance of equity markets over the remainder of 2000 and into 2001.
My first question is to ask if US interest rates have peaked? Since the middle of 1999, the US Federal Reserve has raised overnight interest rates by 150 basis points. US official interest rates are now higher than their previously cyclical peak in early 1995. While US inflation remains very low, signs of an overheating economy have raised fears that it won’t stay low for long. As a consequence, the Fed has been trying to slow the US economy’s growth rate to its long-run potential, or preferably lower, to take the pressure off inflation.
In recent months however, the US economy seems to have taken a breather after its frenetic growth pace of the previous few quarters. The key question for the Fed is whether the economy is slowing in a sustained way, or is it just foxing, and likely to reaccelerate later in the year? If the economy isn’t foxing, then US monetary policy might not be tightened again, and hence one big negative that has been overhanging equities for months is removed.
Will it be a hard or soft landing? What if the US Federal Reserve has already done too much? US official rates are already above previous highs, and the US yield curve is inverted – traditionally a very good leading indicator of US hard landings. While a hard landing for the US economy would prove a boon for bond investors, equity markets are not well placed for a hard landing. Earnings optimism remains extremely high and would be severely dented if a hard landing looked likely.
I count myself firmly in the soft landing camp. While soft landings are tough to achieve, the Greenspan Fed managed to achieve one in 1995. Moreover, hard landings normally require something seriously structurally wrong with an economy. Excessive corporate debt, chronic overinvestment or a distressed financial sector usually does the trick. Structurally, the US economy does not seem to be in the kind of shape that causes hard landings.
The solid recovery in the technology-laden NASDAQ index is nothing short of remarkable. The highly speculative end of the NASDAQ, which embodied the worst excesses of the Internet bubble, has died a painful death, however the quality end of the NASDAQ has proven extremely resilient. The table below shows trailing and forward price to earnings ratios for those US technology companies that I (and most others) would view as the quality end of the NASDAQ. By any traditional comparison, these kinds of price earnings ratios require extremely strong rates of growth to justify current share prices. The scope for earnings disappointment in these circumstances is substantial.
How would the overall equity market react if the big name tech stocks did fail to meet the market’s earnings expectations? It’s something that I, for one, am reasonably relaxed about. A further correction in tech stocks would likely see funds flow again to the old economy where valuations are nowhere near as excessive rather than leave the equity market entirely.
Equity markets are not out of the woods yet. The questions posed above will continue to provide investors with much food for thought over the coming months. When the guy in the ad jumps out of the window again, chances are he’ll still be in for a soft landing.
Brian Parker is chief economist at Salomon Smith Barney Asset Management.
