Client Update – January 10, 2001

Most investors will be glad to say goodbye to the year 2000. The S&P 500 had its worst performance in over 10 years and the NASDAQ suffered its worst loss ever, down 39%. As expected, most Wall Street pundits predict a rising market in 2001 (as they did for 2000). The idea that the market could perform poorly two years in a row seems inconceivable. They will continue to predict the good times until they are wrong several times in a row and then they’ll switch to predicting bad times, but by then we’ll be back into good times.

There are still excesses in the technology sector despite the recent decline in the NASDAQ and tech stocks. Some tech stocks have fallen a lot, but the NASDAQ bubble is not fully deflated. The NASDAQ still sports a P/E ratio of 110, when its long-term average is around 40. That implies that some combination of prices falling over 50% or earnings doubling should take place.

The erosion of stock market wealth will clearly affect spending in the months ahead. Perhaps spending cutbacks will be severe enough to cause a recession instead of a soft landing. However, the Fed will keep lowering rates until it succeeds in stabilizing the economy.

The current shape of the yield curve suggests that the credit markets expect rate cuts of 100 basis points over the next 12 months. The Fed lowered the real fed funds rate to 0% in the early 1990s due to U.S. economic weakness. A similar move today would imply a fed funds rate of 2.5%, much lower than today’s 6.2%. This gives the Fed a rather large net to catch the economy should it fall.

On a more positive note, reasonable values are available in some sectors and many previously neglected stocks are now attracting interest. We will continue to prudently allocate money to those sectors that are the most reasonable and attractive.

While the stock market is no longer extremely overvalued, there are still dark clouds over upcoming earnings announcements. As far as the near term is concerned, we continue to advocate a conservative stance.

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