New Economy bellweather Nasdaq sets off waves of fears

Now, the questions are: How fierce will the bear be? When will it turn? And how and where should investors take shelter?

"There are some worrying signs here," says Richard Schmaltz, a portfolio manager at J&W Seligman, a New York investment management firm. "We’re seeing even the technology leaders suffer here now, a sign that a bear market is here. In a bear market, you sell even the things you love, because you feel you have to raise cash and flee to safety."

Ed Kerschner, market strategist at PaineWebber Group, warns that investors should brace themselves for another 33 per cent decline in what he calls the "new new industrials," or speculative technology companies without earnings that have soared in recent months, carrying the Nasdaq to its March records. "Despite recent price declines, valuations of `new new industrials’ still look excessive by traditional metrics," he said in a note to clients Wednesday. "Further price declines seem likely."

It’s been less than two years since investors last grappled with the dilemmas created by a bear market. In mid-July 1998, only a year after Asian economies stumbled, the US stock market was buffeted by another string of external shocks. The virtual collapse of Russian financial markets raised the specter of a global financial meltdown, and triggered a flight from risk of all kinds.

The result: a world-wide liquidity crisis that cost investors billions of dollars. The casualties included Long-Term Capital Management, a fund for wealthy investors that lost more than $4 billion in the liquidity crunch. The pain, though intense, was relatively short-lived. Despite a flurry of bad news from global markets, and the havoc wreaked by the LTCM collapse on US markets, an interest-rate cut by the Federal Reserve in early October marked the turning point.

By Thanksgiving, the Nasdaq composite had regained all the ground it had forfeited during the bloodbath and was poised to set another string of records. But some scared investors didn’t jump back into the markets until way after the rebound began, and ended up kicking themselves. This time, it may be different. For one thing, the causes of the current carnage are internal. “You’ve come off a period of pretty heady speculation in the market, so you’re adjusting valuation measures back to levels that seem more reasonable," says John Ballen, a portfolio manager at MFS Investments in Boston.

And trying to grapple with internal valuation issues can be trickier than dealing with external shocks. When the catalyst for a market sell-off comes from something that isn’t linked to corporate fundamentals, it is easier for investors to understand, if not accept. "In some ways, this bear has the potential for being a scarier bear market because it is falling of its own weight as investors start to recognize that they have to factor in risk and not just reward," says Edward Yardeni, chief economist at Deutsche Bank Securities. "In previous sell-offs in Nasdaq, there were external events that dissipated quickly,so the market regained its move to the upside. This time around, it looks like a lot of speculators are learning the hard way about old-fashioned valuations."

They are also learning how supply and demand issues can cause market woes, as last year’s record crop of initial public offerings of stock come back to haunt investors. In March, about $58.6 billion in stock that insiders couldn’t previously sell as a result of lockup agreements became available to sell, according to Bradley Alford, who runs an information Web site on lockup expirations called IPOLockup.com.

And there is more to come — lots more. Alford says an additional $67.3 billion in locked stock is free to be sold in April and a massive $137 billion in May. "I don’t like to be a dooms-dayer," says Alford, who also runs the alternative asset portfolio for the Duke Endowment in North Carolina. "But people are starting to call my site ‘short.com.’ "

Some argue that the differences from 1998 will make it harder for the market to snap back to life this time. Schmaltz notes that the Nasdaq composite closed Wednesday near its lows of the day, as investors dumped not just the highflying dot-coms but also longtime market favorites with solid operating histories like Cisco Systems and Intel. "That’s a hallmark of a bear market," says Schmaltz.

Others are still more pessimistic. Mark Strome, who runs a hedge fund, Strome Investment Management, is betting that incessant waves of selling, followed by attempts by the market to rally, could continue for as long as several years. He foresees a 30 per cent to 40 per cent slide in the Nasdaq from current levels. "It could get quite panicky yet. These things tend to go in stages," he says, adding that he believes the market may continue to sell off through the summer and then rally. "It could go two years like that or more. The air could just keep coming out," he says.

"But the level of excitement and greed out there was off the charts. Three weeks ago, my caretaker told me he was selling his dirt bike so he could day trade. It’s just unbelievable," he says.

Amid that kind of carnage, investors such as Strome and Schmaltz are turning to blue-chip stocks in a handful of sectors they believe will withstand a storm. Strome says energy stocks could go up slightly. "Oil and oil services will do OK," he says.

Schmaltz argues that it is time to move into the highest-possible-quality companies, such as downtrodden but solid technology companies such as Microsoft that boast solid revenue, and food companies such as ConAgra or Bestfoods, which jumped Wednesday after reporting better-than-expected first-quarter earnings. Among the buyers of Bestfoods Wednesday was Elizabeth Bramwell, who runs a fund-management firm that bears her name.

Of course, not everyone is so gloomy. "Even Joe DiMaggio could strike out sometimes," says David Liu, manager of the Strong Overseas Fund. "The fundamentals are still there, earnings are there. If the [first-quarter] earnings come through well in the next two or three weeks, people will scratch their heads and wonder why they sold."

It is all a matter of perspective, some say. "Call it a bear market with a little ‘b,’ " says Jay Tracey, manager of the Oppenheimer Enterprise Fund. "I don’t see evidence that there’s the kind of economic problem now that leads to a more extended decline that wears everybody out. It’s not like everyone is selling every kind of stock. This is limited to the sector where the excess was."

Paul Cook, manager of the widely watched Munder NetNet Fund, says he is nibbling at stocks, trying to pick up some bargains. But he is looking for seasoned companies or those with solid business plans. "We don’t want to try to catch a falling knife," Cook says.

So, when will the bear stop growling? When you "get down to valuations that are reasonable and not outrageous anymore," says Ballen of MFS. "Probably, we’re going to have to suffer bit more to shake out the perception that people have acquired that somehow it’s fast and easy to make money in the stock market. You need to put fear back into their hearts and minds."