VERYONE LOVES A GOOD SALE. IT'S hard to pass up a great bargain when you see one, especially when there's a sharp markdown.

Equity investors aren't any different from anyone else in this regard. Following the blowoff in the week after the attack on the World Trade Center, stocks were certainly marked down. It wasn't just your bargain basement speculative stocks, either, as many quality blue-chips were at 52-week lows. Like good shoppers, investors descended upon the equity clearance racks and stocked up on marked down merchandise.

From the lows of September 21st through the end of the year, the S&P 500 rose 19%, the Dow Industrials 22%, the Nasdaq 37%, and the Morgan Stanley High Tech Index 40%. Judging from these numbers, it looked like 1999 all over again.

Party Like It's 1999

Source: Baseline If you were Rip Van Winkle and were just waking from a 2-year nap, you might think nothing had changed in the interim. From the lows in September through the end of 2001, all major indexes had powerful moves upward, led by pre-Y2k leader tech.

But was this really the start of the end of the bear market? After all, we experienced two false starts in 2001 alone -- first in January and then again in late May. Both times the rallies proved to only be brief respites in the ongoing bear market. Is it different this time?

Monetary Schizophrenia

On the face of it, this should be a real concern given this is the same Fed that spent 2000 raising rates from relatively moderate levels when there wasn't even the slightest hint of inflation. Now they've reversed course and suggest there may be more cuts from historically low levels. If these inflation hawks are willing to do that, do they see lingering problems that no one else is yet aware of?

Probably not. Instead we suspect this is just another case of monetary policy overreaction. Historically the Fed has been a poor manager, tightening money supply too much in the face of inflation and then overshooting when easing.

That's exactly what we've seen in the most recent cycle. The Fed's ill-advised tightening in 2000 precipitated the current recession. Now it's quite likely they will -- if they haven't already -- go to far in easing.

Back in January 2000 when the Fed embarked on their tightening policy, we feared the Fed had already tightened too far (see What If?). Six months later (see Be Careful What You Wish For) we warned,

There's a 9-12 month lag between Fed action and its effect on the economy. At this point, the economy already appears to be slowing with only the effects of the first 1/4-1/2 point increase. Odds are, when the rest filters through, we'll be on the brink of a recession.

Unfortunately, we were right, as the recession officially began nine months later in March 2001.

Now the opposite is occurring. As the nearby chart illustrates, the money supply (M2) is already growing at a pace last seen in 1982 when the economy emerged from recession. Given the 9-12 month lag between Fed action and the effect on the economy, the monetary growth rate can continue to increase well into 2002. If, as the general consensus holds, the recovery begins around mid-year, the money supply will still be expanding along with the economy.

Pump It Up

Source: Baseline Even before the Fed started raising interest rates, money supply (M2) growth had been falling. This trend persisted from the start of 1999 throughout 2000. Following the rate cuts of 2001, the growth rate spiked up, taking it to levels not seen since when the economy emerged from recession in 1982.

Here's our first prediction for 2002: There will be at least one Fed rate increase before year end.

Why? Start with the fact that when starting from a low base, interest rates usually rise .2-.8% in the first year of a recovery. Add to that the fact that the money supply is high and getting higher. As a result, bond investors and the Fed will panic when the economy begins to strengthen. Remember, these are the folks that believe growth leads to inflation, and rapid growth only speeds the process.

If the economy does turn in the middle of 2002, bonds will fall and the Fed will react to prop them up and head off potential inflation -- just like in 2000. Rising rates -- or even the threat of them -- will dampen the recovery if not choke it off entirely.

P/E is a BFD

Which brings us back to stocks. The equity market is a leading indicator. It usually rallies 3-6 months before the economy turns. If that's true this time, last autumn's gains signal the beginning of the recovery around mid-year 2000 -- just like the economists' consensus.

But the end of the recession doesn't mean stocks will be off to the races. In fact, it's our sense that they're already more than halfway around the track. To see why, consider the basic Price-to-Earnings (P/E) ratio.

P/E is a traditional means of valuing stocks or stock indexes. The idea is as simple as it is elegant: If you divide the stock's current price by its projected earnings, you get a measure of how many dollars you're paying for a dollar of earnings. Investors are often willing to pay more for companies with higher earnings or greater growth rates. These companies typically have higher P/E ratios. On the other hand, companies with falling profits or declining earnings growth aren't as coveted so usually sport lower P/Es.

Historically when a recession ends, the market's P/E falls to around 14-16. As the recovery takes hold, the P/E expands to around 20 or more. To put things in context, the S&P 500's P/E was over 30 before the Fed hurled us into recession. That was clearly an overvalued market as a P/E of 27-28 would be the most you could reasonably justify, even in a low-inflation environment.

S&P 500 P/E Ranges

Source: Baseline The S&P's P/E ratio tends to contract when the economy weakens and expand at market peaks. P/Es were over 30 in 1999 and 2000 at the height of the bull market. Those rates weren't sustainable, yet the P/E is currently at 23 so how far can it expand even if there's a recovery in 2002?

As 2001 came to an end, the S&P's P/E was already 23. That makes sense given the tremendous autumn rally (increasing 'P') and the fact that earnings were still near their trough (minimizing 'E'). If 27-28 is still the maximum you can reasonably expect for a market P/E -- and we think it is -- then how much higher can prices rise without a commensurate increase in earnings?

As you'd expect, many individual stocks are well into overbought levels. For example, Cisco, Intel, and EMC trade at 67x, 42x, and 37x, respectively.

And no, it's not just tech that's trading at lofty valuations, it's stocks from all sectors such as Wal-Mart (39x), GE (30x), and Pfizer (33x). In essence, the stocks that led the autumn rally have already seen most of their sustainable gains. Their prices are already reflecting a nice economic recovery.

With stocks already at these levels, bonds are still a viable alternative. A quick and relatively reliable way to compare stock and bond valuations is to invert the bond's yield to get a figure comparable to the stock's P/E. With the benchmark 10-year Treasury yielding 5.0-5.1%, its "P/E" is 20 or less, well below the S&P's 23 and the Dow's 22. If rates edge up in 2002 -- and we think they will -- bonds will become even more attractive. This is not a scenario for a rousing rally in the equity market.

Valuation Does Matter

If there's anything to be learned from the tech bubble and subsequent bear market it's this: Valuation matters. Prices, whether they be of stocks, bonds, or tulip bulbs, can't continue to rise in a vacuum. We've always believed -- and continue to believe -- that it's ultimately earnings that move the market.

Given this, here are the rest of our predictions for 2002:

• 2002 will be a better year for equities than 2001.

• The economy will begin its recovery, possibly starting as early as the 2nd quarter.

• Interest rates will edge up with bonds -- especially government securities -- returning less than their coupons.

• By year end, fixed income investors and the Fed will again be obsessing over the specter of inflation.

• Earnings growth will resume, but only in the single digit levels for the S&P 500.

• Stocks will close the year higher than they begin it, but the gains will be tame when compared to other post-bear market rallies.

Don't misunderstand, we're optimistic about 2002. While we don't see tremendous gains across the board, there are lots of opportunities for investors who are willing to do their homework. Unlike 1999 when everything went up and it was just a question of how much, those who pay close attention to valuation will be amply rewarded.

Sure some stocks are already overvalued, but not all are. Some are cheap for a good reason, but others have simply been left behind. The investors with the best returns at the end of the year will be the ones who can avoid overpriced stocks and cheap dogs, and who concentrate on the companies that can grow earnings along with their stock price.

Contrary to the ratio's name, the 'E' really does come before the 'P'.

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