Tech Stocks Out–Bonds and Gold In?
By Terry McKolskey, Noble Securities Ltd.

Remember the anticipation as the year 2000 approached? It seemed that we all expected something spectacular, but alas, it turned out to be just another birthday for Mother Earth . . . Or was it?

Whereas none of the widely forecast catastrophic events occurred, it may well be that major changes were, in fact, taking place–we just didn’t notice at the time.

The changes to which I am referring are economic in nature. The world’s financial markets have taken on a decidedly different tone since the big clock struck 2000. Let’s look at some facts: In the first quarter of the year 2000, the major indices of the U.S. stock market (and most of the rest of the world for that matter) reached all-time high levels, possibly marking the end of the greatest bull market in financial assets in the history of mankind. Why the end? Well, as of late summer 2002, the Dow Jones Industrial Average has declined roughly 25%, the Standard & Poors (S&P) 500 has dropped 40% and the tech-heavy Nasdaq has plunged a dazzling 77%.

There’s more. The U.S. dollar, which has been the world’s currency of choice for many years, seems also to have peaked and as of August, 2002, is down more than 12% from its high against a basket of the world’s other currencies, principally the euro, the Japanese yen and the British pound. Corporate earnings are down, the U.S. trade deficit is through the roof and debt levels, both government and private sectors are setting mind boggling high standards. Interest rates, on the other hand, have been driven to multi-year lows.

So what does this all mean and how might it affect you and me?
From an investment perspective, it may mean that we need to change our expectations and our strategy. Economies have always been cyclical; expansion and contraction is as normal as the breathing of a human being. Inhale, exhale. Now whereas the economic expansion of the 1980s and 1990s was at a rate that was no better than average (it was longer than normal), the stock market–inspired by pie-in-the-sky, dot-com fantasies–soared, generating rates of return that were 200 to 300% of the long term average. This “mania” produced an extreme level of overvaluation and it seems that it is now “time to pay the piper.”

In spite of the substantial correction that has already taken place, many argue that stocks are still overvalued and thus not likely to generate great future returns like those of the 1990s. One of the world’s most highly regarded investment gurus, Sir John Templeton, recently offered that “none of the world’s equity markets are currently presenting great values.”

The statistics seem to support that view: The century-long average price-to-earnings (P/E) ratio of blue chip common stocks is approximately 14. The S&P 500 index currently (July) sports a lofty P/E of 26. And worse, if the collective earnings of those 500 companies are re-stated on the more conservative (and more accurate) GAAP basis, the ratio jumps to a frightening 40!

Talking about conservative reporting, one of the key contributors to the “bursting of the stock market bubble” is a loss of trust and confidence on the part of investors. And who can blame them? Enron/Arthur Anderson, Worldcom, Global Crossing, Xerox and countless other examples of creative accounting have produced understandable skepticism.

So this, combined with the effect of increased terrorism and global political confrontation, has put the brakes on global economic growth to at least a much slower pace, if not outright decline.

The response of the U.S. Federal Reserve has been the typical dropping of interest rates and turning on of the dollar printing press. This flood of liquidity has cushioned the blow, but has come at the expense of the value of the U.S. dollar. By definition, this action (by the Federal Reserve) is inflationary and whereas there are no signs of price inflation (CPI), the currency is certainly being diluted.

So what is an investor to do? Here’s the good news: No matter what the economic/market conditions may be, there are always good opportunities. Finding them, though, requires constant vigilance and creative thinking.

Historically, the price of gold has been a good hedge against weakening currencies and there is a groundswell of believers developing. During the 1970s, the dollar was under some pressure: Viet Nam, Nixon resigned and the last major spike in inflation, which peaked in 1980-81, was triggered by the Arab oil embargo. Gold responded with a rally from a low of $36 per ounce in 1970 to its 1980 all-time high of $850 per ounce.

This writer has seen a number of recent essays predicting below-average rates of return for stocks over the next several years and as previously stated, the downside risk is probably not gone either. If this turns out to be true, the focus of successful investors will likely be on more conservative portfolios that are much more heavily weighted to bonds and other fixed income or dividend paying instruments. A global currency diversification will surely also be popular, as will investing/speculating in gold and other precious metals (the next mania?). Hedge funds that do not depend on rising markets for positive returns are now in vogue as well.

Lower rates of return will also impact spending habits and as the consumer pulls in his horns, the concept of actually saving money might be re-discovered.

After an era that has incorporated many excesses, (consumer spending, debt–both private and government, “creative accounting,” CEO compensation, stock valuations, Wall Street research that was tailored for corporate finance needs, insider trading, (ad infinitum), financial services companies are going to have to work very hard to earn and maintain the trust of their clients.