Last Updated May 2000

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ONE OF THE SUREST SIGNS THAT A market bubble is about to burst is when caution flags go up, but rather than heed them, investors argue that "It's different this time." This has been the case ever since "exuberance" became irrational.

And who can deny it? Quality stocks like Sun Microsystems and Cicso Systems sport triple digit P/Es. Start-up IPOs with no "E" trade in the same range if not higher. This is exuberant but certainly not rational.

Every other time P/Es reached the top of their range (not to mention breaking through the top as is the case today), sharp corrections and bear markets have ensued. Still investors cling to the belief that it's different this time.

But stockholders aren't the only ones making this argument. In fact, you'd probably be surprised by some of the others. Let's take a look:

Monetary Policy: Raise Rates While the Economy Slows

• Inflation, as measured by the PPI and CPI remains at the low end of the historical range, putting the U.S. on target for another year in the 3-3.5% range.

  Commodities Roll Over

  Source: Baseline From the trend in the CRB Index, oil may not be the only commodity that's peaked. Unless it's different this time, falling commodity prices don't usually lead to inflation.

   

• There's very little evidence of pricing power in the market. In other words, few manufacturers can increase prices without losing significant market share.

   

• Despite a tight labor market, you have to have x-ray vision to find any sign of wage inflation.

   

• With the latest OPEC production agreement, oil quickly fell from its mid-$30s peak back down to the low-$20s. At the same time, the CRB's 50-day moving average rolled over, indicating other commodities had peaked as well.

   

• The stock market -- Alan Greenspan's nemesis for the past four years -- also seems to be returning to reality. First quarter corporate earnings, while good, may have hit their zenith. Even companies that enjoyed a blow-out first quarter warned this was the high point for the year.

Slowing earnings are usually a leading indicator for a possible recession. But according to the Fed, it's different this time. Rather than gauging the effects of their earlier moves, the Fed is determined to keep increasing rates until -- well, who knows?

Fed-fretters point to the April's CPI release that came in higher than expected. Of course, this report reflected the short-term spike in petroleum prices and besides, one in a row doesn't typically establish a trend.

The Fed has actually made this same argument whenever inflation comes in below expectations. But then again, it must be different this time. So different that the Fed will continuing tightening credit regardless of the facts.

Bonds: Prices Increase With Rising Interest Rates

After peaking well above 6% earlier this year, the long Treasury bond is now back in the 5.80 - 5.95% range. The 10-year note -- rapidly becoming the benchmark standard -- trades slightly higher, around 5.90 - 6.05%. All of this in the face of the recent rate increases and threats of more. In fact, bond holders believe the Fed will continue raising rates, yet Tresury's remain strong.

Treasury Strong Bond

Source: Baseline Despite the Fed's tightening, the yield on the 30-year Treasury Bond has continued to fall from it's early year highs. This isn't supposed to be happening.

Of course, something really is different this time: The Treasury is periodically buying back existing bonds. This is really a pretty prudent use of the current accounting "surplus" since it allows the government to retire older, higher-coupon debt. Each time a repurchase occurs, the amount of outstanding Treasurys falls. As the laws of supply and demand would dictate (at least they aren't different this time), lower supply drives up the price of remaining issues. This, it's argued, is why Treasury bond prices can rise in the face of increasing rates.

It's also supposed to explain the inverted yield curve. Typically the yield curve is upward sloping as investors demand higher yields to compensate them for holding longer bonds. (For illustrations of Treasury yield curves, see March's True Facts.) But now the 30-year bond's yield is below the 10-year's and both are less than the two-year note. Presumably, this is because the Treasury is buying back longer bonds (reducing supply) while shorter notes reflect the threats of future rate increases.

But in the past, an inverted yield curve was a precursor to a recession. High short-term rates choke off economic expansion while lower long-term rates are a prediction of lower future inflation and growth. But hey, it's different this time.

Equities: Buy Economically Sensitive Stocks in a Rising Interest Rate Environment

What's up with that? We've always believed earnings moved the market -- those companies that had the best prospects for future earnings and growth were rewarded with higher stock prices. With the Fed raising rates to slow the economy, do you think the best earnings prospects lie in financials (Loans 'R Us), basic industries (Buy this cement, please!), or consumer cyclicals (Half-price sale on diamond solitaires!)? Probably not unless it really is different this time.

Earnings Disappointment? Sell!
Blow-Out Earnings? Sell That, Too

Pop Quiz

Source: Baseline Quick now, which of the following companies reported earnings disappointments and which surpassed expectations -- IBM (IBM), Intel (INTC), Citrix Systems (CTXS), Motorola (MOT), and Microsoft (MSFT)? Trick question! They all beat the estimates although you couldn't tell from their post-announcement performance.

As we move further away from first quarter earnings reports, the next thing on the horizon is the second quarter earnings confession period that will begin in mid-June and run through the first week or so of July. As the Fed's interest rate boosts take hold, look for more confessions and fewer earnings blow-outs. You won't have to worry about companies with great earnings being taken out and shot simply because there won't be very many with great earnings.

What's Not Different This Time

But it's our feeling that things really aren't different this time. Rising interest rates will slow the economy and if they rise too fast, recession rather than inflation will become the crucial concern. The Fed has a long history of overshooting its target and it probably will again unless of course, it's different this time.

As long as the Fed maintains its hawkish stance, interest rates should remain steady if not move up. Earlier in the year they had moved too high so As far as the equity market is concerned, the utter lack of alternatives helps explain investors' willingness to stay with stocks even in the face of increased volatility.

An added bonus is the surprising "stickiness" of 401(k) dollars. For most individuals, their largest investments are in their employer-sponsored 401(k)s. Throughout the recent market turbulence, these investors have remained extremely stalwart. Whether it's because they're true believers in long-term investing or just don't pay that much attention to their retirement account, the result's the same: a lack of panic selling.

So does this mean high-flying earningsless stocks can continue to survive on momentum alone? Let's not get carried away here, it's not that different this time! Quantitative studies show that the S&P 500 can be fairly valued with P/Es in the high 20s, but not 130s, 200s, or no "E" at all. If nothing else, April's selloffs may have brought a little reality back into the market. While tech and biotech stocks with real earnings should do just fine, "concept" stocks with no timeline to profitability will be given the emphasis (or lack thereof) they deserve.

Odds are, the bull's not dead, it's just finding its feet. When it does, leadership will fall to tech (real companies, not spec-tech), communication services, cap goods with a heavy tech orientation, and healthcare. Don't count on financials, cyclicals, or basic industries until interest rates stabilize.

Sometimes when markets are turbulent, the best thing for long-term investors is to just do nothing. And that's not different this time.

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