A roundtable discussion: Making sense of the moves in the markets

Where will the stock market go in 2001? Will technology stocks rebound? Is a recession likely?

To ponder these questions, we gathered three of the best thinkers in the financial markets, two who offer advice from New York and one who manages money from Minnesota. Douglas Cliggott, the United States equity strategist at J. P. Morgan, who correctly forecast that the Standard & Poor`s 500 would end 2000 at about 1,300, down from 1,469.25 at the close of 1999, is cautious again this year. So is James W. Paulsen, the chief investment officer of Wells Capital Management, a money management firm in Minneapolis, and a man who has often picked up changes in the economy and markets before they become conventional wisdom. But Chris Callies, the top American strategist for Merrill Lynch, who a year ago was correctly warning that tighter monetary policy could hurt stock prices early in the year but hoped for a rebound later in 2000, argues that pessimism is way overdone and has confidence that the Federal Reserve will deal with the economy as well as it has in previous years.

Talking with Gretchen Morgenson and Floyd Norris of The Times, the three agreed that interest rates were headed lower, at least in the next few months, but they differed on the fate of the dollar.

Following are excerpts from that discussion:

Q. This was the first year in a while that the market did not have a good year. Is that going to continue in 2001 or are we back to the good old days?

CALLIES We probably lean more toward the good-old- days scenario but not out of any conviction that the equity market deserves to go up every year or maybe 6 times out of 10.

We think that one of the more important drivers of equity market performance is Fed policy, followed, I think in close second position, by liquidity growth. And based on the Fed`s recent statements it does sound as if they are preparing to cut interest rates. Our forecast calls for as many as four interest rate cuts in 2001. This will help initiate at least a temporary rise in equity market multiples. We think they could go as high as 27 times operating profits and that would translate to a target by the end of the second half or the third quarter of 1,720 on the S.& P.

So that would be a very nice gain from these levels.

Q. Jim, is it going to go up that much?

PAULSEN I don`t think quite that much. The stock market in 2001 will probably produce some positive return but not a lot. I think it`s going to be mainly interest rate driven.

I think it will also be very sector-specific. We might get a continued underperformance of technology and economically cyclical areas. The more economically defensive and bondlike stocks might carry the S.& P. up somewhere close to 10 percent, which should be at or less than what you might get from a long bond.

CLIGGOTT We see 2001 as almost being two different years. Roughly speaking, the first six months would look and feel a lot like the past six months. So our guess is that by the end of June a lot of stocks will be lower than they`re trading at now. Most of the indices that we look at will be lower than they start the year.

We respect the power of bond yields; we respect the power of liquidity. But what we`re really struck by is both the breadth and maybe the velocity of the slowdown we`re experiencing right now.

Our guess is it won`t really be until the market has the courage to look into 2002 that investors will start to get a little bit of confidence in earnings again. That`s really the first hope that you could get for the broad market to be moving higher.

Q. Where will the S.& P., the Dow and Nasdaq end 2001?

CLIGGOTT Fourteen hundred for the S.& P., 11,000 for the Dow and 2,500 for the Nasdaq.

PAULSEN About 1,450 for the S.& P., 11,250 for the Dow and probably 3,000 for the Nasdaq.

CALLIES Sixteen hundred on the S.& P. 500, 11,500 on the Dow and the Nasdaq probably about 4,000.

Q. Where will the 10-year Treasury be in a year?

CLIGGOTT About where it is now, near 5.20. The story on interest rates is a steeper Treasury yield curve.

PAULSEN I venture to say we touch 4.5 percent on the 10- year, but by the end of the year it`s 4.75 percent.

CALLIES Rates start down, then start to flow back up before the end of the year. I would say high fives. Short rates do go down.

Q. Anybody see a recession coming in 2001?

PAULSEN I think there are some decent odds.

CLIGGOTT I think we may be in one.

PAULSEN The economy faces a kind of double whammy. It`s not only facing a traditional policy-induced slowdown — which is brought about by the combination of rising rates, tight fiscal policy, the strong dollar killing off refinancing cash flows, taking real wages back to negative growth — but also on top of that we have the tech sector in clear slowdown. And I don`t really see a catalyst to restart it. The combination will put us very close to recession.

Q. Chris, you shake your head no.

CALLIES One of the characteristics of this business cycle has been that we have had localized slowdowns in a particular sector, which allows other areas that might be, so to speak, in the sweet spot of their own business cycles, to keep the economy going.

There are two key areas of the business cycle that are important right now. First is personal consumption expenditures, the kinds of things that people buy every day for themselves. One of the leading indicators as to what consumers will do is the extent to which they borrow money and their ability to buy either new or existing homes. New-home sales have been coming in at a rate that is fairly close to the high end of the cycle, and because home activity is interest rate sensitive and because long-term interest rates have been coming down, we think that the consumer side of the economy will prove to be reasonably resilient.

To be sure, it`s probably not going to accelerate, but we would point out that consumer activity even in the third quarter of the year for durable goods did accelerate to a growth rate of over 8 percent. To meet the official definition of a recession, which is two consecutive negative quarters of G.D.P., you`d probably have to really impair the confidence of the consumer, and we don`t think that that has happened yet.

PAULSEN I think the consumer has some real question marks if we do slow down. One is the tremendous amount that they`ve purchased in durable goods, as Chris lays out, not only in the last year but for the last several years. That spending is way off the chart in terms of its historical average to overall spending. That suggests there could be a huge saturation risk here. Once you buy all the houses and cars and computers, how many more do you really want, even if they make them attractive to buy?

CLIGGOTT You don`t want three Suburbans in your driveway?

Q. Doug, you said you thought we might be in a recession. What`s the evidence for that?

CLIGGOTT Whether we look at housing or autos or the stuff we stuff into houses, like the news we got from Apple and Gateway and Maytag and Whirlpool, it seems household discretionary spending is slowing in a fairly pronounced way. Every American household has been hit by the increase in energy costs and many by the negative wealth effect from the equity market.

I think that it`s only a question of when, and not if, we`ll see the unemployment rate rising in a meaningful way. That will give you the second round of slower consumer spending.

On the business side, heavy- trucks sales have just collapsed; telecom equipment is slowing down; computers are slowing down. Semiconductors look like they`re slowing down fairly viciously. Industrial equipment`s slowing down.

I don`t think there`s anything the Fed can do this winter that will affect the first half of 2001. I think what the Fed can do this winter is influence the depth and the length of the slowdown. But they can`t prevent it from happening. It`s really too late for that.

Q. Jim, what`s your feeling on G.D.P. for 2001?

PAULSEN One of the reasons that we may all be hesitant to call it a recession is because recession calls just haven`t worked. In some regards, we should have had a recession in 1995 after the Orange County debacle, and another in 1997 when the whole world melted.

I would suggest the United States avoided the last two possible recessions, in `95 and `97, because of technology. In the early `90`s, tech was about 5 percent of the change in the real G.D.P. Between 1994 and 1995, it went from 5 percent to 15 percent, and it was that surge in PC`s, the PC revolution, that kept real G.D.P. from slipping to two negative quarters and the recession. Then after Asia occurred, we had an Internet revolution, and that took tech from about 15 percent up to about 32 percent of economic growth. I think we`re now facing the same sort of situation, but we do not this time have something on the magnitude of the PC or the Internet to cover up the rest of the cyclical slowdown that we did in the last two crises.

CLIGGOTT That`s right. In `95, as consumer spending slowed, technology spending actually accelerated. The same thing happened in `97. The reason why we think a very meaningful slowdown has probably already started is, where are you going to go from 25 percent growth in tech? It seems to me there`s only one answer, and it`s down. If we go to zero percent growth in tech, the Nasdaq`s not going to stop at 2,000; it`s going to go a lot lower than that.

Q. Chris, I know you`re bullish on technology stocks. What`s your view on where we go from here in tech?

CALLIES There are a couple of issues to remember about this correction. We think it was primarily a multiple compression. And we say that because we do have reasonably good economic history of what capital spending slowdowns look like in tech and what some of the triggers were. This correction, big though it was in Nasdaq and tech, is one of the very few that occurred with new orders for old-economy tech — these are the commodity things like desktops — growing at between 20 and 30 percent year over year. So it really was not a correction that was occurring in tandem with some type of collapse in demand for tech. There was some defensive overordering by companies, and there is a minor inventory problem in certain areas of tech, but if demand remains at a relatively decent level, let`s say maybe 10 percent growth instead of the 22 percent people have been accustomed to, the inventory problems will basically take care of themselves.

Compare this correction and this cycle in tech to one that was a bona fide bear market both for demand and production and capacity utilization and relative share prices, the one that occurred from 1983 to roughly 1992. During that period, you did see a very substantial deceleration in capital spending on tech down to the mid- single digits. Once the sector got hit, it stayed depressed for quite some time.

Q. You don`t think that`s going to happen again?

CALLIES I think that the market has already discounted that. The one index that was most heavily weighted with technology shares, the Nasdaq composite, was down 50 percent from the peak in 2000. This is the second-biggest decline in the Nasdaq except for 1973-`74. That market corrected enough then to tolerate an eventual decline in capital equipment spending of 8 percent year over year.

Now we would suggest that capital spending for 2001 is probably not going to go from 22 or 23 percent in 2000 to minus 8. We think that something around the 10 percent range is reasonable and that the equity market, in trying to correct the optimistic excesses, has gone to a comparably large pessimistic excess.

Q. What`s G.D.P. going to do in 2001?

CALLIES My colleague Bruce Steinberg thinks the quarterly growth rate will be between 2.3 percent and 3.8 percent.

PAULSEN I think we`re going to do more like 1.5, perhaps maybe a little less. And that might come with a quarter or so that`s zero or negative.

Q. Doug, what are we going to get?

CLIGGOTT Our economics group is looking at 2.5 percent growth for the year. Their weak quarter is 1.5 in the first quarter. I think the risks to their numbers are to the downside.

Q. Are we in a credit crunch now or is one coming? What will its effects be?

CLIGGOTT Capital is much less available to start-up ideas than it was a year ago. And I`d say that encompasses both the high-yield market, the equity market and global capital markets. The willingness to fund high-risk ventures has receded in a fairly violent fashion.

The reason this matters so much is that essentially 100 percent of the incremental growth in capital spending is coming from either new debt or new equity. Corporate America`s got a pretty significant free cash flow deficit and so to keep the capital expenditure engine running, we need to have friendly capital markets.

On the consumer side, I don`t see an availability-of- credit issue. You still have lenders tripping over themselves, throwing money at households.

Q. It`s fairly clear that the Postal Service would be in trouble if banks stopped mailing out credit card applications. Jim, what about the credit situation?

PAULSEN The whole below-investment-grade world has gone from where a year ago they had essentially free cost of capital in the equity market and a relatively reasonable debt cost to where it`s become infinitely costly in the equity market and almost prohibitive in the debt market. So we certainly have a crunch going on in below-investment-grade credits.

That brings up a lot of questions about the potential uniqueness of this credit crunch. If we have record postwar high-yield spreads when the economy`s growing at 3 to 4 percent, what happens if we slow the growth rate? And can the Fed do anything about that? Could it be possible that when the Fed starts to ease, the risk premium in corporates goes up faster than the impact of their easing, so many potential borrowers see their rates rising?

Then there is the strength of the dollar. The dollar keeps going up even in the face of a massive trade deficit. What happens if the Fed starts to ease? It would like to lower the value of the dollar to restart the U.S. economy. But the dollar could go up because the world risk premium forces investors into the safety of the dollar.

Q. Chris?

CALLIES We think that there is a highly selective credit crunch primarily for lower-rated borrowers, whether they are businesses or consumers. It`s the Fed`s opportunity to either blow it or pull off a soft economic landing without a broad-based credit crunch.

In order to have a major negative economic impact, we believe that a credit crunch has to expand to encompass most segments of the economy and most levels of the lending process. It seems that bankers have been applying higher credit standards only to their lowest- rated customers. As a result, it`s possible for banks to say that they are becoming stingier with credit during a period in which bank loans and leases and consumer credit growth are both actually accelerating up to the 8 to 13 percent range on a year-over-year basis.

It`s quite clear that the credit markets have shut down for some of the lower-rated credits, particularly in technology, media and telecom. But one of the reasons that might be the case is the relatively large levels of issuance, not just in the United States but globally, in these industries. Part of the issue might be that investors have saturated their portfolios with this type of debt.

We think that the credit crunch actually is quite selective. And as long as it stays selective and is accompanied by fairly robust credit growth in other areas of the economy, it will probably not have a major impact on the overall business cycle.

Q. If we have a slowdown in the U.S., are there any areas overseas that might be able to pick up some of the slack? Doug?

CLIGGOTT Our guess is Europe could grow a little faster than the United States in 2001. But it`s more that we slow down faster than than they do. I don`t think anyone knows what the Japanese economy`s going to do.

PAULSEN There is a question whether or not we ever extinguished the Asian crisis. When we look back, I wonder if we`re going to find out that the Internet boom in the United States paused or delayed a worldwide Asian event. Maybe it would have been best had we not had that. Then U.S. and European officials would have eased much more aggressively after Asia and for a longer time. The U.S. would have stayed slow and maybe taken care of a lot of the lingering Asian problems. As it is, we went right back to tightening within months of the low in Asia. As a result of that, we never really brought the rest of the world clearly out of that.

I think that Japan is probably in recession at this point and a lot of the Asian tiger countries are close to that. Europe is in better shape. But we`re going to find out just how strong the world is without the U.S. importer. Not only does the U.S. cycle slow, but maybe the rest of the world even slows more on the back of that.

CALLIES We probably wouldn`t differ too much in terms of what areas of the global economy seem to be reasonably healthy and which ones don`t. The consumer economy in Japan still appears to be moribund. Until that changes, it`s going to be hard for the Japanese economy to be one of the main drivers of global growth. Europe would be one part of the global picture that might be able to grow reasonably well and tolerate some minor fluctuations in the United States, but there, too, we rely to some extent on the wisdom of policy makers. We would rather not see any further tightening of monetary policy there.

One of the more interesting aspects of this past year was the extent to which tech drove a lot of investment patterns. One of these we`re still experiencing in the form of the relatively persistent strength of the dollar versus the euro, which we suspect will change within the next year. But foreign investors have had a terrific appetite for U.S. assets, and it`s not just financial assets but cross-border mergers and direct investment in the United States.

CLIGGOTT With our current account deficit now, I think we need about $1.2 billion a day to come into the United States in investments, and that includes Saturday and Sunday. You don`t need Europeans to lose their appetite. All you need is for them to be a little less hungry and you could get the dollar moving, and moving pretty quickly in the other direction. Since the data have gotten weak, since the Fed has acknowledged the weakness of the data, you`ve basically had the euro going up and the dollar going down.

An important piece of the financial puzzle in 2001 could be a reversal in the dollar. If I`m sitting in the Federal Reserve and the dollar`s going down while the economy weakens, that complicates my inflation outlook and the policy response.

PAULSEN It`s interesting that we still carry this legacy of worrying about inflationary pressure. It seems to me when you look around the primary thing corporations are struggling with is the inability to lift their prices. If there`s intense price competition when we`re growing at a 5 to 6 percent real rate, what happens if we slow and the dollar even goes up more and puts even more intense pricing competition into the equation? That`s what I`m worried about.

CALLIES I guess my perspective is inherently a little different. We`ve been looking at a lot of international crises going back several decades, and it seems to us that a lot of the potential for the U.S. economy and for the U.S. stock market resides in the hands of domestic consumers and domestic investors. International investors can add spice to the mix, but, for the most part, the Treasury markets and the equity markets seem to do best when domestic investors are in the process of a big asset-allocation change — out of fixed income, out of cash and into equities.

So my concern longer term, both with respect to the economy and the stock market, would be the extent to which some of the short-term deceleration in the consumer confidence surveys is the beginning of a major trend. The timing of this latest deceleration in consumer confidence is interesting because it occurred at the point when the then-unresolved presidential election contest was getting just a little bit more combative than usual. My guess is that it will recover as we start 2001, in part because, although we would expect to see some upward creep in the unemployment rate, a lot of businesses are indicating that they would like to hire more people.

Q. I was wondering how long it would take before anybody mentioned we had an election. We`re going to have a Republican Congress with a very narrow majority and a Republican president with something less than an overwhelming mandate. What difference is this going to make?

CLIGGOTT To me, it`s all downhill. An idyllic environment for equities is a very tight fiscal policy that allows the Fed to run a very easy monetary policy. That describes the lion`s share of the 1990`s and one of the reasons equities did so well. We`re going to witness an easing of fiscal policies, and, as a result, monetary policy will be maybe a little bit, maybe quite a bit, tighter.

PAULSEN I don`t think the election makes a lot of difference. Probably similar things would have occurred regardless of whether Bush or Gore was elected. The whole election premise was the idea that we had this one-time chance to really do something because we have this nice surplus. It would be perfectly ironic if, by the time the legislature debates what to do, by next August or so the surplus is gone because the recession hit and welfare expenditures went up and tax receipts went down.

CALLIES There`s some question as to exactly how the Bush administration will try to advance its agenda. It sounds as if they are going to return to the tax-cut program that was not that long ago referred to as dead-on- arrival by a lot of people. To the extent that some of this program is passed and is phased in over the next year or so, my guess is it will help serve as a safety net under the U.S. economy. I`m not convinced it`s necessarily a bad thing because, if it is phased in, the economic effects could stretch out over time and thereby not necessarily constitute an inflationary stimulus to the economy. I don`t think it necessarily will translate to something that the Fed needs to combat by backing off of the easing policy that it seems to be embarking on for early 2001.

Q. Chris pointed out that stocks do well when American investors move money from other assets into stocks. What`s the outlook there?

CLIGGOTT That asset-allocation point is hugely important. It looks like a lot of Americans have come to the realization that they own a lot of stock and maybe they don`t need to own more of it right now. I think that the person in the street is in a little bit of a state of shock that the equity market can go down like it`s going down. It`s been a long time since that happened. The risk over the next 12 to 18 months is that you see some people all of a sudden being interested in a C.D. again that`s yielding 5 or 6 percent.

Q. Anybody else? Is the love affair with stocks starting to fade?

PAULSEN I don`t think it has yet. Despite the fact that we`ve collapsed tech stocks by 50 percent, the market, even when it was down 5 percent in a day, did not seem panicky at all to me. I would feel better about the tech thing being done if there was a sense of a major panic and a movement away from stocks. I don`t think we`re there.

CALLIES The American investor is surprisingly resilient, and I don`t know if this is necessarily a good thing or a bad thing. I suspect that they have been chastened, but I don`t think that they are ready to give up yet on equities or for that matter on technology. And I don`t know that I would argue with this very much either. When you look at the earnings power of the other sectors of the S.& P. 500 over a long period of time, one of the lessons that comes through fairly strong over several decades is that unless the equity markets are faced with a significant inflation problem, growth-type companies — and by this I mean companies that are involved in some type of new technology, which sometimes is health care, not necessarily just software and networking — have generally produced some really spectacular returns and over some fairly extended periods of time.

What would concern me is a type of asset deflation that would hit the markets quite conspicuously. For instance, 1987, `88, `89 is an interesting period for gauging consumer behavior and the ability to tolerate disappointment. During that period, two major financial asset classes — actually three if you want to include the bond market, but I`m thinking here of the S.& P. and the Nasdaq — went down fairly substantially.

And as a consequence, in part, of changes in the tax code that occurred around the same time, investment in real estate and then later the prices of primary residences, certainly in this area, were under a fair amount of pressure. That pressure didn`t really lift until employment began to accelerate in 1993. People did back off from the equity markets at that point, briefly.

Q. Let`s talk about what to buy.

CLIGGOTT We`re very defensive. We want you to own stocks like Procter & Gamble. In financial services, we want you to own insurance stocks. An insurance stock we like is Ace Limited. Health care, we like H.M.O.`s and pharmaceuticals, such as Cigna and Schering-Plough. We don`t think it`s too late to own energy. A couple we like are El Paso Energy and Ultramar Diamond Shamrock.

PAULSEN The sectors that are interesting — even though they`ve done pretty well in the last several months — are the old-line unit growth areas, which are largely staples and health care. I would look at Colgate and Pepsico and McDonald`s. Their growth rate is not really that different from what it was a year ago or two years ago, but it`s much more attractive when the high-octane part of the growth market now has a risk premium in it and the economy itself is growing much more slowly. And I think, if the economic reports continue to worsen, that it`s going to drive investment in those areas.

Others would be the bondlike areas, which would be the utilities, financials, perhaps some integrated oils.

Q. Tell me some growth stocks you like.

PAULSEN I stick to the old-line staples in health care, Abbott Labs and Merck. I would stick with some of those monopoly-type large-cap plays because I think we`re going to find out that, if the economy slows again, small-cap starts to underperform large-cap.

CALLIES I guess the difference for us is that we believe that the U.S. economy has an extremely high probability of enjoying, if I can use that phrase, a soft economic landing. The equity market leadership in the first half of 2001 probably will reflect benign soft-landing leadership themes in conjunction with the Fed easing. This would mean selected financial services shares, consumer cyclicals. Technology actually has been a prominent leader associated with Fed rate cuts in a soft economic landing environment.

One area that ordinarily would do well in this type of a situation that we don`t wish to pursue for 2001 is health care. This is primarily because of the valuation profile of the major pharmaceutical stocks. They are selling at approximately 80 percent of their maximum relative multiple over the last 10 years, and we have discovered that, no matter how high quality the growth of a sector that has this characteristic, it has been very difficult to sustain outperformance.

We are focusing on the tech sector for two reasons. First, while we agree that it will slow down, we just don`t think that it`s going to slow to a negative number, and we believe the market actually has positioned for that negative outcome. We think that, as expectations normalize to something that is more consistent with economic activity in tech, we`d go back to some things like Analog Devices. The pressure on tech companies to keep costs under control is going to benefit the outsourcing or the contract manufacturers, so we like Sanmina. In the semiconductor area, we`d like to look at some of the higher-quality names like Xylinx.

We also think that growth at a reasonable price as a general theme will return in part because the multiple expansion that I was referring to earlier is likely to be temporary. Investors really should not want to be heavily exposed to high P.E., ultrahigh momentum shares, if in fact P.E.`s are going to be fairly volatile. There is a fair amount of growth at a reasonable price in the S.& P. 500. That`s one of the reasons that we think the market leadership will broaden out in 2001. A lot of it is in the quality retailers, such as Kohl`s and Talbots.

There are some structural supply- demand imbalances developing in the U.S. economy. The State of California has made a wonderful example of supply constraints in electric utilities. We prefer the hybrid companies that have a portion of their old captive customer base as well as some of the new-economy electric space, typically exemplified by the merchant power generators or the companies with wholesale power trading operations. This is one of the reasons we like Duke Energy.

And in the energy sector, we see a similar supply-demand constraint story for very similar reasons, just basically underinvestment in these two areas, the mirror image of possibly some overinvestment in technology. We`d like to look at some of the integrated companies, like Chevron, for the next phase of the energy cycle.

Q. Thank you all very much.

(http://www.nytimes.com/2001/01/02/business/02ROUN.html?pagewanted=all)