Which of the following is true?

A. The U.S. stock market has not lost its mind. Most stocks, even high-tech issues, are fairly valued. Consumers are not highly leveraged. Inflation is quiescent. The outlook: The bull market will continue.

B. Investors in U.S. stocks have reason to worry about an equity "bubble." The divergence in value between tech stocks and blue chips is alarmingly wide. Consumers are amassing loads of debt and using some of it to buy equities on margin. Inflation is looming. The outlook: Be prepared for a further correction.

No matter which answer you choose, you will have a lot of company. And you will find that some of the people who agree with you are pretty astute investors.

Consider the people who made presentations at the opening session of the weeklong conference of the Securities Industry Institute that began March 12 at Wharton. Making the case for the bulls were Joseph V. Battapaglia, chief investment officer at Gruntal & Co., and Patricia Chadwick of Ravengate Partners. Taking the less sanguine view of the market was Gail M. Dudack of Warburg Dillon Read.

Battapaglia: Bull Market, Part II

"We are poised at this moment, in my view, for the next leg of the bull market," stated Battapaglia.

Battapaglia said inflation remains under control and that the only wild card that could push prices skyward was oil. But he predicted that recent rising oil prices, which have angered motorists and sent the presidential candidates scrambling to figure out a way to exploit a pocketbook issue, would decline to $25 a barrel in six to nine months.

"Oil prices are not to be feared, nor are commodity prices," he said, adding, "Inflation is not going to rear its ugly head."

The Federal Reserve has been raising interest rates higher in recent months. But Battapaglia said the quarter-point increase in the federal funds rate on March 21–and another he expects in May–"should end the invasion of the Fed in the marketplace."

"Soon," he added, "the Federal reserve will go back to a neutral mode, which is when markets operate best."

Another reason for Battapaglia’s bullishness is his outlook for corporate earnings. He said profits of companies in the Standard & Poor’s 500 index should rise by an average of 12.5% in 2000, spurred by, among other things, an increase in exports.

Even more compelling, he said, is that major NASDAQ companies should see their profits soar by a greater margin this year. In response to analysts who fear that technology stocks are wildly overpriced, Battapaglia pointed out that of the 5,000 or so companies in the NASDAQ Composite, 1,900 of them account for 95% of the index’s market capitalization.

It is these 1,900 firms, he said, whose earnings should rise 35% in 2000. Moreover, the price/earnings ratio of these firms is an average 56, which he said was appropriate given their anticipated growth rates. "This does not speak of excessive [stock prices]," he said. "It speaks of market efficiency."

Battapaglia forecasts that, by year’s end, the Dow Jones Industrial Average should reach 12,000, the NASDAQ index 6,000.

Chadwick: An "Enormously Advantageous Position"

Chadwick was as bullish as Battapaglia.

"The investing environment remains extremely favorable today," said Chadwick, who then reeled off the reasons for her optimism.

For one thing, the U.S. continues to enjoy low inflation. Indeed, she said, the country is witnessing what she termed "positive deflation," spurred by productivity gains from the growth of new technologies.

Chadwick said the last time that inflation was so benign – at the same time that the economy was booming – was during the last 25 years of the 19th century when the United States witnessed the emergence of such mighty industries as railroads and automobiles.

"(Gross domestic product) grew 4% to 5% a year in that period and inflation was negative," she said. Today, the United States is the world’s center for technology innovation. When "the rest of the world" needs technology, "they come to U.S. companies."

Overall, Chadwick said, "the U.S. is in an enormously advantageous position" relative to its competitors around the world, many of whom have yet to fully embrace free markets. "Europe is primarily a social welfare system," she said, leaving it unable to take advantage of the kind of free-market forces that have benefited the U.S. economy.

Chadwick criticized "xenophobic" politicians of both the left and right who wish to restrict immigration. "Here’s an opportunity to open our borders and let the educated and the uneducated come in" to contribute to an expanding economy.

Chadwick acknowledged that rising interest rates were "troubling" because they historically have caused consumers and businesses alike to curb spending, thus creating the risk of an economic slowdown or even recession. "But since we don’t have a manufacturing, inventory-driven economy, interest-rate hikes are not as significant as they once were," she said. What’s more, "many tech companies have no debt. They go to the equity market for financing."

She urged the money managers and financial advisers in the audience to be invested in technology companies, even though there will be "a lot of casualties and blood spilled. It behooves you to know it, understand it and be a part of it."

Chadwick forecast that earnings of S&P 500 companies would rise 15% in 2000.

Dudack: Bursting the Bubble

Dudack took a more sober view of the market, which she said was suffering from a "bubble" that has been driven in large measure by "clients pushing money managers to be in technology [stocks]." Dudack said she herself was taking part in the process of causing the bubble: "I must confess I’m buying stocks today that make me throw up."

Her talk focused on what she said was the chief question her clients have been asking: How can an investor tell that the end of a bubble in equity prices is near?

Some of the signs of economic distress, Dudack said, are these:

    • The U.S. trade deficit is at a record 3% of GDP
    • Investors are borrowing lots of money to invest or speculate in the market. Margin debt is nearly 2% of the market capitalization of all stocks listed on the New York Stock Exchange, a level that is well above the norm
    • Household debt has risen sharply and now stands at 68% of GDP
    • The Fed is raising the cost of borrowing by boosting interest rates
    • Despite some wild gyrations, the stock market has not really appreciated in the past year or so
    • People who do not normally invest in the market are doing so with a vengeance. Fully 28% of household net worth is in stocks.

Specifically, she said, NASDAQ stocks have "way exceeded any bubble I’ve ever seen." What is more, she noted, even the Dow has reached a height that reminds her of Japan’s equity market, as measured by the Nikkei 225 index, which collapsed a decade ago and has yet to recover.

At one point, Dudack directed the audience’s attention to a slide showing that the advance/decline line–“ the number of stocks going up in price as opposed to those declining in price–“ had peaked in 1998. "This," she said, "is why I believe a bear market is in place. It’s a very narrow market," with tech stocks far outperforming blue-chips in recent months.

She predicted that the Fed would raise the federal funds rate at least two more times in 2000, in addition to the quarter-point hike on March 21.

On the bright side, Dudack said, the market has risen so dramatically in recent years that "a 30% correction would not be the end of the world" for investors who have benefited from much or all of the market’s advance. One exception, she said, would be investors who have mortgaged their homes to buy stock.