So, Like, the Old Economy Isn’t Dead?

The best thing about this immense two-day rally in the Dow Jones Industrial Average and the S&P 500 Index (aside, of course, from all the money we’ve made) is that it may shut up, at least for a while, all the financial columnists and advisers who last week were sounding the death knell for not just the Old Economy but also for index-fund investing.

You remember last week, don’t you? That’s when Procter & Gamble warned that its earnings were going to miss estimates, and in reaction most big-cap non-tech stocks sold off. Now, the P&G news was important, and the magnitude of the sell-off was striking. And there are good reasons–most of which I’ve probably beaten to death here–for why fast-growing New Economy companies tend to be more highly valued even than fast-growing Old Economy companies. But none of these factors should have led one to the conclusion that the Dow or the S&P were dead in the water, or that active money management–either by hedge-fund managers or by individual investors–had now become an automatic route to success.

The fact is, after all, that if you’d taken the advice of those Net pundits who advised you to pull money out of your S&P index funds (since those traditional big-cap stocks weren’t going to turn around anytime soon) and put it into the tech sector, you would have missed most of this remarkable rally. Which is not to say, of course, that now you should imagine that the valuations on the Dow and the Nasdaq are suddenly going to start converging. It’s only to say that the market’s short-term direction is, by its very nature, unpredictable, and that imagining that you can call rallies and sell-offs with any degree of reliability is simply delusional.

In the long run, the stock market is not governed by momentum investing or fads or hype. At its core it still represents an attempt to discount the future free cash flow of the companies that comprise it, and even if in the short term it fails to apply the same discount rate to all those companies, eventually it does something very much like that. (That doesn’t mean that all companies have the same price-to-earnings multiple, because how efficiently a company earns money matters immensely.) There’s so much publicity surrounding the Internet and the New Economy right now that it’s easy to fool yourself into believing that traditional principles of business and investing are no longer relevant. But the basic truths about the market have not changed, the most important of which is that the market knows more than you do. Whatever else this week did, it made that point emphatically.