Déjà Vu All Over Again? The Case Against a "2000 Tech-Stocks" Meltdown By Ernie Ankrim, Chief Investment Strategist Russell Investments January 31, 2008 Typically, bears hibernate until spring. Now, in the dead of winter, stock-market bears seem to have emerged from their lairs to devour everything in sight. As I write, I'm reminded of the U.S. market's "record setting" low January performance in 1990.1     Return as of Jan. 31, 1990   Return as of Jan. 17, 2008 Russell 1000   -7.1%   -9.4% Russell 2000   -8.7%   -10.1% Russell 3000   -7.3%   -9.4% S&P 500   -6.7%   -9.3% Dow Jones Ind. Avg.   -5.9%   -7.8% The point, of course, is not where 2008 stands in the list of poor performing Januarys. Rather, it's that the New Year symbolizes a time for hope—Halloween is months behind us—yet we're off to a scary start. This, not surprisingly, has led investors to seek historical parallels to gain some context for decision-making. I'm hearing two questions:   Will today's Financial Sector repeat the bust of 2000's Technology Sector? If so, are we headed for another equity meltdown like that of 2000-2002? My short answers are... maybe and I don't think so. While I'm confident in my opinions, I am required—and justifiably so—to acknowledge the impossibility of a guaranteed forecast. But I can reveal my thinking, and here it is. Four clouds in our crystal ball Uncertainty remains a constant in challenging times. Four considerations make it difficult to offer a definitive answer to the question of whether we're in for another Tech Bust: 1. We don't know what the Fed's surprise rate cut will do. On January 22, the Federal Reserve Board held a between-meetings videoconference and cut the Fed Funds rate by ¾ point from 4.15% to 3.50%. This was the biggest cut for this target rate since 1990 and the first time the Fed cut rates between meetings since 2001. The Fed also lowered the discount rate by ¾ point to 4.00%. More cuts may follow. Wall Street wasn't exactly enthused about the Fed rate cut. The Dow plunged 465 points after the opening bell then rebounded but still closed down 128.11 (-1.06%). The Russell 1000® closed down 34.3 (-1.05%). The next day, January 23, bargain hunters pushed the Dow up 298.98 (+2.50%) and the Russell 1000® up 69.4 points (+2.15%). And the markets enjoyed nice gains—though not as much—on the 24th. Let me offer a brief response to the Fed's cuts. Whether investors will be upbeat in February and March remains to be seen. The Fed obviously recognized the pervasive fear evident in the overseas markets on Monday, January 21 (when U.S. markets were closed). The Fed made a statement that it understands the market's concern; Ben Bernanke and the governors are watching the market and the economy very closely. Remember though that the Fed focuses on dual objectives—economic stability and inflation control—and will give its attention to both. See my full remarks for details. 2. We don't know what impact the economic stimulus package will have. On January 24, President Bush and The House agreed on a preliminary stimulus package. It includes tax rebates of $600 to $1,200 for some tax filers and rebates of $300 to others plus business tax cuts. However, we won't know the effects of this package until late this year at the earliest. The "too little, too late" syndrome always threatens to raise its ugly head. 3. We still don't know the magnitude of the balance-sheet damage to the Financial Sector. The subprime-lending story will continue to unfold in the days, weeks and months ahead. Obviously, what we learn will help us better assess current and potential future damage. Meanwhile, we'll wait for one or more other shoes to drop. 4. Market volatility likely will continue. Re #1 above, bargain hunting has its limits. As with the stimulus package, we'll have to wait for results. Looking forward, the market will remain volatile. Until the economy shows signs of righting itself, small rallies will represent taps on the brakes of a vehicle still heading downhill. We may be approaching the bottom—although where that will be is tough to predict (market timers, beware!). I believe this turbulence will be with us for some time. A helpful historical review: some cause for optimism. So are we headed for disaster? A brief historical review suggests that the current "Financial Fall" will not be as bad as the Tech sell-off. Further, while more bad news may lie just over the horizon, more than half of the damage probably is behind us. Here's what we know... The Financial Sector of the Russell 1000 peaked on June 1, 2007. From then until January 18 represents a period of 231 days. We can compare the Financial Sector's run to what happened after the peak of the Russell Technology Sector, a period of 231 days from September 1, 2000 through April 20, 2001. The table below summarizes the return experience for these two periods.     Post-peak Returns (231 days)   Post Sell-off Returns (next 365 days)   Post Sell-off Returns (2nd 365 days) R1TECH (peak 9/1/00)   -51.4%   -30.5%   -25.3% R1FINL (peak 6/1/07)   -31.8%   ?????   ?????? The sell-off from peak in Financials has only done about 60% of the damage turned in by Tech stocks in a similar period. The Tech decline from 2000 through 2002 contributed to one of the worst 36-month equity experiences in recent U.S. market history. The 36 months ending March 2002 resulted in a -16.1% annualized return on the Russell 1000. This represents the worst such period since the 36 months ending July 1933.2 While equity return patterns rarely repeat themselves, the sell-off from peak in Financials has, so far, produced only 60% of the damage turned in by Tech stocks in the first 231 days of disappointment. That's serious. But I don't expect subsequent declines to come close to repeating the successive declines over two years we saw in Tech stocks. Why? Excuse the pun, but Tech stocks started from a much higher jumping-off point. A bit of apples and oranges Tech stocks generally sell at a higher-than-average earnings multiple than stocks in the broad market. From 1995 through 2007, the Tech Sector price/earnings ratio averaged 1.65 times the broad-market P/E. At the peak in 2000, Tech stocks' P/E was 2.25 times the P/E of the Russell 1000. In contrast, Financials tend to sell at a lower-than-average earnings multiple. The average P/E for Financials over the last 13 years was 0.62 times that of the broad market. However, at their peak in 2007, Financials sold at 0.75 times the P/E of the Russell 1000. Obviously, Financials were more expensive than average at their peak in 2007. However, the degree of above-average valuation was smaller than that of Tech stocks in 2000. Another point. The relative P/Es tell us that at their peaks, these sectors were richly priced. Okay, that's no surprise. But these P/Es don't reveal anything about how richly priced the stock market was as a whole. There's a simple method for measuring the nature—cheap or expensive—of equity prices. Divide the current price by the expected earnings over the coming 12 months (expected P/E) against the inverse of the yield on a relevant fixed-income yield. For purposes of this illustration, I'll use the long-term "A" rated corporate yield reflected in the Moody's A index series.     Forward P/E   A-rated "Bond P/E" R1000 Avg. 1987–2007   17.2   12.8 R1000 Sept. 1, 2000   27.1   12.5 R1000 June 1, 2007   16.4   16.6 R1000 Jan. 18, 2008   17.3   16.7 Stock P/Es remain higher than those for bonds, reflecting the growth of corporate earnings tied to the economy and productivity. The logic behind stocks' slightly higher P/E than that for bonds comes from the fact that bond earnings (coupon payments) don't normally change over time. Corporate earnings grow at rates related to economic activity and firm efficiencies. The "Tech Bubble" market of late 2000 saw stock P/Es over two times higher than "Bond P/Es." This stands in stark contrast to both the 21-year average (with equity P/E's 34% higher than the bond ratio) and both recent observations (where the equity and bond P/Es are close to equal). To stay objective, let's acknowledge a problem with this analysis. It assumes the same level of credibility assigned to the "expected" portion of the forward P/Es. But in our current environment, serious doubts arise that earnings expectations formulated earlier in the year will be realized as the economy continues to show signs of significant slowing. How badly might Financials suffer? And is the market rich when we incorporate more conservative earnings expectations? Let's see. To take the extreme view, I calculated what the forward P/E would be for the Russell 1000 Index assuming that the Financials Sector produces zero earnings. Also, I kept the price of the Index at its current level, so the burden of zero-earnings Financials is accompanied by prices reflecting valuations greater than zero. I also went back to 2000 and performed a similar calculation—assuming that Tech stocks would never have earnings—to see if the market was especially expensive. Russell 1000   Forward P/E   Forward P/E with TECH ('00) of FINL ('07, '08) earnings = 0 Sept. 1, 2000   27.1   29.9 June 1, 2007   16.4   23.4 Jan. 18, 2008   17.3   19.4 Today's P/E multiples for stocks are far lower in comparison to those for bonds than at the time preceding the Tech collapse. The adjusted forward P/E for the Tech Sector in 2000 was nearly 2.7 times the comparable bond multiple. At the same time, today's market multiple—assuming zero earnings for Financials—is still only 28% above the bond multiple. This is below the average for the last years. Thus it's hard to view this environment as the same as that of the market at the beginning of the Tech sell-off. Discipline: time to walk the walk Sure, it's understandable that investors are skittish in our current environment. A weakening economy and substantial write-downs by Financial firms makes reading about or listening to descriptions of market actions a painful exercise. But some observations about the similarities to the 2000-to-2002 period of market pain offer long-term investors a reasonable degree of comfort. (For investors with short investment horizons, substantial equity investments rarely make sense.) Every long-term investor must ask this question: "If I get out now, when will I be comfortable enough to get back in?" It is much easier to get out of a scary market than it is to get back in before the market recovers. Experienced investors have faced tough periods before and survived nicely. They know the answer: stay in. This approach represents the hard part of being a disciplined investor, but it's the right approach. I believe that as bad as some of the coming days might be, we don't have another Tech Sector disaster staring us in the face. What's more, we may well be past the halfway point leading to a return to better times. We may not be seeing the light at the end of the tunnel now, but we know it's out there—and we'll reach it. When it comes to going through investment cycles, history definitely does repeat itself. Fasten your seatbelt. The going will be bumpy, but a brighter tomorrow lies somewhere ahead. 1Ibbotson's & Associates US Large Cap Equity series, 1926-2007, determined January 1990 as the worst January since 1926. S&P and Dow Jones data identify January, 1970 as the worst January. 2Ibbotson's & Associates US Large Cap Equity series, 1926-2007. These views are subject to change at any time based upon market or other conditions and are current As of January 31, 2008. The opinions expressed in this material are not necessarily those held by Russell Investments, its affiliates or subsidiaries. While all material is deemed to be reliable, accuracy and completeness cannot be guaranteed. The information, analysis, and opinions expressed herein are for general information only and are not intended to provide specific advice or recommendations for any individual or entity. Nothing contained in this material is intended to constitute legal, tax, securities, or investment advice, nor an opinion regarding the appropriateness of any investment, nor a solicitation of any type. The general information contained in this publication should not be acted upon without obtaining specific legal, tax, and investment advice from a licensed professional. Forecasting represents predictions of market prices and/or volume patterns utilizing varying analytical data. It is not representative of a projection of the stock market, or of any specific investment. This is not an offer, solicitation, or recommendation to purchase any security or the services of any organization. Russell 1000® Index measures the performance of the 1,000 largest companies in the Russell 3000® Index, representative of the U.S. large capitalization securities market. Russell 2000® Index measures the performance of the 2,000 smallest companies in the Russell 3000® Index, representative of the U.S. small capitalization securities market. Russell 3000® Index measures the performance of the 3,000 largest U.S. securities based on total market capitalization. S&P 500 Index: An index, with dividends reinvested, of 500 issues representative of leading companies in the U.S. large cap securities market Dow Jones Industrial Average: Price-weighted average of 30 actively traded blue chip stocks. Standard & Poor's Corporation is the owner of the trademarks, service marks, and copyrights related to its indexes. Indexes are unmanaged and cannot be invested in directly. Indexes and/or benchmarks are unmanaged and cannot be invested in directly. Returns represent past performance, are not a guarantee of future performance, and are not indicative of any specific investment. Price-Earnings Ratio (P/E Ratio) - A valuation ratio of a company's current share price compared to its per-share earnings. Federal funds rate is the interest rate at which a depository institution lends immediately available funds (balances at the Federal Reserve) to another depository institution overnight. Please remember that all investments carry some level of risk, including the potential loss of principal invested. They do not typically grow at an even rate of return and may experience negative growth. As with any type of portfolio structuring, attempting to reduce risk and increase return could, at certain times, unintentionally reduce returns. Copyright© Russell Investments 2008. All rights reserved. This material is proprietary and may not be reproduced, transferred, or distributed in any form without prior written permission from Russell Investments. It is delivered on an "as is" basis without warranty. Russell Investment Group is a Washington, USA corporation, which operates through subsidiaries worldwide, including Russell Investments, and is a subsidiary of The Northwestern Mutual Life Insurance Company. Securities products and services offered through Russell Financial Services, Inc., member FINRA, part of Russell Investments. For information on the Financial Industry Regulatory Authority, go to www.finra.org. RFD 08-7398. First used: January 2008.			Comment on this PERSPECTIVE What is your impression of Ernie Ankrim's insights? Are there topics you would like to addressed in the future? Provide your feedback.   WHY Russell? See the difference Russell's investment approach can make   Printer friendly version of this page Send feedback or comments Site Search

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