Last Updated March 1999

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UST A FEW SHORT MONTHS ago there was concern about the duration of the domestic economic expansion. The so-called "Goldilocks" economy was just about perfect -- not too hot, not too cold, just right. Perhaps it's now time to change fairy tales as Alice (Investors?) in Wonderland suddenly seems more appropriate. Consider:

• Brazil devalues the real and everyone fears dire repercussions for Brazil's trading partners (especially the U.S.), instead the U.S. stock market soars to new highs.
   
• In the 4th quarter of 1998, economists frighten investors by warning of slowing domestic growth, but it turns out GDP grew at 5.6% -- not slow by anyone's estimate.
   
• Only two months ago, the main fear for 1999 was recession but after 4th quarter statistics showed no such signs, concerns now focus on possible Fed rate increases.
   
• Japan's long-term interest rates hover around 2% yet bond investors are pulling money out of U.S. bonds at 5%+ to purchase them.
   
• Analysts warn that slowing corporate earnings will drag down the stock market, however profits for the S&P 500 have risen 4.2% with the majority of companies of all market capitalizations exceeding 4th quarter estimates.
   
• Dell Computer Corp. announces sales growth of 38% (including a 30% increase in Asia) but below the 56% averaged over the past eight quarters so within a week, Dell's stock falls over 21%.
   
• All of this occurs while "investors" bid up Internet stocks with no earnings (or even potential earnings) to absurd levels.
   

In the words of Alice, things are getting "curiouser and curiouser".

"We're All Mad Here."

In an effort to prove the Cheshire Cat's observation, bond investors proved they were no saner than equity investors by immediately overreacting and sending the rates on the long Treasury bond up from around 5% to about 5.7%. Japanese investors furthered the reaction through their seasonal repatriation, pulling funds out of U.S. bonds and bringing them back home for the March 31 fiscal year-end. The additional supply from the Treasury's quarterly refunding didn't help either.

But it was an overreaction. While the U.S. economy continues to expand, it's doing it at a sustainable rate. Even though the Fed may have no additional cuts forthcoming, there's certainly no reason to fear an eminent tightening. Greenspan's no Knave of Hearts and won't be stealing the interest rate tarts. If anything, U.S. rates are already relatively high relative to our peers. Japan's remain below 2% while both Britain and the European Union will probably need to consider cuts to head off recessions. As a result, current rates should again attract foreign investment, moving the 30-year Treasury back towards reasonable levels of 4.8-5.1%.

"You Can't Take Less, It's Very Easy to Take More Than Nothing"

Anyway, the Fed controls the short end of the curve, not the long end that predicts of inflation. Right now, inflation looks pretty tame with little or no threat from either wages or prices. Commodity prices continue to set new lows while the renewed strength of the dollar puts pressure on exports and encourages imports. All of these factors make it difficult for domestic producers to raise prices. While this may not be good for corporate profit margins, it's excellent news from an inflationary standpoint.

There is, of course, a certain degree of fretting about the tight labor market. Unemployment is at the lowest level in years and there's always the possibility that labor unions will seize this opportunity to reassert themselves in contract negotiations. While it's quite true that the unemployment rate probably won't fall much further and its next move is likely to be up, to paraphrase the Mad Hatter, it's a lot easier to go up when you're coming off a low.

Even so, a slight increase in wage levels won't immediately throw us into the grasp of the wage-price spiral. Keynesians may have at least been right to point out that a little inflation is good for the economy. (They weren't right about much else, mind you.) Counterbalancing the potential inflationary effects of the tight labor market is the deflationary effect of technology. Yes, technology is making us all (with the possible exception of a sleepy Doormouse) more productive.

The biggest threat to the inflation picture is fiscal policy. Your president's state of the Union address was pretty good evidence that big government isn't dead, it was just taking a brief vacation. At a rate of 7 promises per minute (I'm not making this up), he proposed program after program of wasteful government spending. (Is "wasteful government spending" redundant?) Nevertheless, if Congress remains gridlocked on passing any of these boondoggles, the inflation picture can remain pretty serene. Look for it to remain steady with only a slight increase towards the end of the year.

"Sentence First -- Verdict Later"

OK, continuing growth, low inflation, and moderating bond rates should all be good for the equity markets but almost all of the gains from January have been retraced in February. Sure, the NASDAQ was overdone with the zany Internet stocks, but the other indexes are back to where they started, too. Like the Red Queen, investors seem to be sticking to their sentence of poor returns despite the 4th quarter's favorable earnings verdict.

Right now, the stock market has a lot in common with the U.S. government -- leadership is definitely lacking. Technology stocks had a major stumble in early February as the Internet stocks took a hit (well-deserved, of course) and the usual bellweathers, IBM, Microsoft, Sun, and Dell ran into a market of Red Queens shouting, "Off with their heads!" There's still a certain amount of concern that once the market-leading techs collapse, the rest of the market will come with them.

Ominously, with the S&P 500 roughly where it was at the same time last year, only 192 (38%) of its component stocks are outperforming the index meaning the other 62% are lagging. In addition, over half are actually lower than where they finished 1998 with a median loss of 2.4%. Remember what happened to the 1970's "Nifty Fifty" and the bear market that lasted most of the decade?

There's no questioning the fact that valuations are at extremes and many stocks (not just Internet stocks) are overvalued. While you certainly don't want to fall into the trap of saying, "It's different this time," it is quite true that in a low inflation, slow growth economy investors can safely pay more for future earnings. In other words, P/Es can be relatively high. The question is, how high?

Clearly Internet stocks have separated themselves from reality. Perhaps Price-to-Dollars spent is a more appropriate way to value them than Price-to-Earnings. At any rate, quality companies -- the ones with real earnings, market share and niche products -- can continue to move ahead as long as demand persists. This doesn't just apply to tech favorites, but also to such beaten down stocks as Dupont and Schlumberger which have recently shown some signs of life. While it's still probably too early for them, a broadening of the market advance is certainly a good sign for the continuation of the bull market.

Another positive sign is the dispersion of earnings growth. As the accompanying chart shows, not only have the majority of reporting companies exceeded 4th quarter projections, this positive earnings trend holds across all market capitalizations. Maybe the White Rabbit isn't too late to the party just yet.

For the present time, several sectors continue to offer the most promise:

• Technology -- companies that are market leaders with proven products and steady demand. Now the stocks are on sale.
   
• Healthcare -- more and more emphasis in this area as baby-boomers age. Best bets are pharmaceutical companies with strong pipelines and medical device manufacturers.
   
• Regional Banks -- avoid money-centers with foreign exposure and stick to regionals that are not overly dependent on interest rates. Focus on those able to derive earnings from a high percentage of non-interest income.
   
• Consumer Cyclicals -- that's right, consumer cyclicals. Perhaps it's a little early but if the economy continues to show strength, larger companies with strong markets may come back into favor…

With valuations at such extreme levels, investors will continue to react like Mad Hatters to any news that can possibly be viewed as negative. Although 1999 appears to be a volatile year for the markets, economic conditions are still close enough to "Goldilocks" to make the risk worthwhile.