If sagging economy has begun to recover, why are stock prices still in doldrums?

By DAVID MOON, Moon Capital Management
April 7, 2002

After an euphoric fourth quarter in which investors seemed eager to put the financial woes of 2001 behind them, lethargy returned to the overall broad markets. During the just completed first quarter, the NASDAQ Composite resumed its losing ways, declining another 5.4 percent. The S&P 500 likewise declined, although only slightly (less than one percent.) Lead by old economy stalwarts Boeing (up 24.4 percent), General Motors (also up 24.4 percent) and Phillip Morris (14.9 percent), the Dow Jones Industrial Average increased 3.8 percent. First quarter Dow losers included the most 'tech-ish' of the thirty: IBM, AT&T, Hewlett Packard, Microsoft, General Electric, SBC Communications and Intel. (When Microsoft and Intel were added to the Dow Jones Industrial Average, who would have ever imagined those companies being a drag on the Dow's performance?)

Value funds again outperformed their growth counterparts in the first quarter. It is now two years since the overall market peak in March 2000. Since then, the S&P 500 and NASDAQ have declined 25 and 63 percent respectively. (This, despite a nearly 30 percent increase in the NASDAQ since September 21, 2001.) During those same 24 months, the S&P 500 Value index declined only 8.57 percent.

Economic growth appeared to have been robust during the quarter. In fact, Federal Reserve board chairman Alan Greenspan now questions whether or not we were ever in a recession. (Of course, he still has a job, so the question is much simpler for him to pose.) If we did have a recession, it was certainly mild ' not the consumer whopper expected by many, including me. But consensus estimates are that the U.S. economy grew five percent or more in the first quarter; whatever economic weakening we experienced is over (for now.)

So what happened to stock prices? If the economy grew during the first quarter, why did most investors continue to lose money? Because there is a difference between the economic performance of a business and the price of the stock of that business. (The value of that business is a third nondependent ' but related ' variable.)

The first negative influence on stock values during the first quarter was an increase in interest rates. When interest rates increase, the values of most financial assets decline. Since the value of a business is just the present value of all of the future expected cash flows of the business, as interest rates increase, the present value of those future cash flows decline ' even without any corresponding decline in the expected cash flows.

The other factor-creating headwind in the stock market was the significant general price increase during the fourth quarter of last year. The value of the 500 stocks in the S&P 500 did not increase 10.7 percent during the fourth quarter, although the 'price' of the index did. You might argue that the value of those companies did not decrease 14.7 percent during the third quarter when stock prices plummeted. But that argument ignores one important point: stock prices were generally too high at the beginning of the third quarter of 2001. Extraordinarily positive performance in the fourth quarter merely returned the prices to their earlier overvalued state. The merger and negative returns in the first quarter of 2002 support that notion.

David Moon is president of Moon Capital Management, a Knoxville-based investment management firm. This article originally appeared in the News Sentinel (Knoxville, TN).

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