The Emperor’s New Economy

January 4, 2001

Dear Investor:

There’s a saying among philosophers: marry a good spouse and you’ll become happy; marry a bad one and you’ll become a philosopher. The paraphrased version should be: ride a bull market and you’ll become rich; ride a bear market and you’ll become an economist.

It seems that in the wake of the worst year for a major stock market index since the Great Depression, everyone has traded in bull market excitement for the dismal stripes of dour economic prediction. If the lesson of the past year is anything, it’s that markets change on a dime and thus the important thing to manage is risk.

2000 will go down as a supremely historic year: the year the internet bubble burst, the worst year in the Nasdaq’s history (down 39%), the worst year in the broad markets since the 70’s, and finally, the year that the Emperor’s New Economy asked for clothes.

The carnage in the Internet sector is astonishing, even to students of past collapses. The average retail Internet stock is down over 90%. The Jacob Internet Fund, a poster boy for New Economy excess shunned by us and many other advisors, is down over 79%. Many dot-coms have closed their virtual doors. Many more will follow suit over the next few months. An erstwhile darling of the B2B internet space, Interworld Ventures (INTW) lost 99.4% of its value, forcing its founder to sell his brand new $20,000,000 already mortgaged Palm Beach mansion. A million dollars invested in Interworld at the peak is now worth $5,900. Priceline.com’s (PCLN) founder, Jay Walker, has resigned and Captain Kirk has beamed himself back down to Earth. A million dollars invested in Priceline.com at the peak is now worth $9,533. TheGlobe.com (TGLO), first hailed as a great innovation, then exposed soon after as a greatly bad investment, faces delisting from the Nasdaq after 30 days with its share price below a dollar. A million dollars invested in TheGlobe.com at the peak is now worth $8,200. The list goes on and on.

Now that market pundits are finally calling this bear a bear, we may have hit bottom. The market is certainly pricing in a slowdown if not a recession, and leading indicators point to at least one quarter of negative growth. A potent leading indicator, The National Association of Purchasing Management’s factory index, fell to 43.7 in December, its fifth monthly decline and its lowest reading since April 1991–during the last recession. We believe this is what hurriedly prompted the Fed to slash rates by 50 basis points this week. Given sustained Fed intervention, a massive compounding of the slowdown is unlikely. Even Morgan Stanley’s chief macro economist Stephen Roach (and one of the most accurate forecasters), who has been bearish all year, predicts the downside of 2001 worldwide GDP growth at 3.0 – 3.5%, a far cry from full blown global recession.

Our view is that the market has seen the bulk of its declines but that bear psychology will linger. Future stock market returns will be anemic compared to years past and patience will rule the day. But stock market returns historically discount future real economic events six to nine months hence. Thus, it’s plausible that the 2000 Bear Market, which began in March, may have discounted the current slowdown sometime ago and that market returns have already borne the brunt of their misery. If the economy resumes its growth in Q3 or Q4, then stock market returns would soon start pricing in that recovery. And if the Fed accommodates by further loosening the money supply, the stock market could recover faster.

The bottom line is to remain invested with an appropriate allocation. Just as it was hard to imagine why the stock market was sliding when the economy seemed invincible, it will be hard to understand why the stock market will be rising during the depths of a slowdown. A case in point: In the languishing economy of 1991, the S&P 500 returned 30% as it priced in the future recovery. Psychology in markets is always counter-intuitive due to the discounting mechanism just described. The most common bear market mistake is to liquidate investments once a recession has already taken hold.

The saving grace is that the calamity we all feared during the Great Bull Market of the 1990’s has finally occurred: the markets collapsed and euphoria with it. The speculators have been vanquished, but those who managed risk are still standing, willing to bide their time until the riches resume.