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Stock Analyst Update

The Year in Stocks: A Tumultuous 12 Months

Terrorist tragedy made an already bad market situation worse in 2001.

As with virtually everything else in 2001, the history of the stock market can be divided into two distinct periods--before and after September 11. In addition to the terrible human toll of the terrorist attacks, the financial impact was also harsh, as the already-weak U.S. economy suffered a shock it could ill afford. Economists are now saying that the current recession started in March, but nobody doubts that the attacks made an already bad situation worse.

For the second straight year, all the major stock indexes will finish 2001 down substantially from where they started the year. Through December 14, the Dow Jones Industrial Average was down 9%, the S&P 500 was down 15%, and the Nasdaq Composite was down 21%. Yet all three have bounced back from their post-September 11 lows, and the Fed's aggressive interest-rate cuts have at least helped keep the market damage from being worse. As we all ponder what 2002 will bring, both for our portfolios and for the world in general, here's a look back at some of the market highlights and lowlights of this tumultuous year.

Mergers
The torrent of mergers resulting from the giddy bull market of the late 1990s became a trickle in 2001, especially in the early part of the year. Some of the biggest deals to close in 2001 were actually announced the previous year: the merger of Chevron and Texaco to form ChevronTexaco (CVX), Pepsico's (PEP) purchase of Quaker Oats, General Mills' (GIS) purchase of Pillsbury, and of course AOL Time Warner (AOL), which didn't close until January 2001. Among the most important deals left over from 2000 was the one that didn't happen: General Electric (GE) called off its $40 billion merger with Honeywell (HON) in June after European regulators balked at the deal and demanded too many concessions.

There were some multibillion-dollar deals in the first half of 2001, but none quite as sexy as the megamergers of the 1990s. In pet food, Nestle (NSRGY) bought Ralston Purina; in finance, AIG (AIG) bought American General, and Wachovia (WB) bought First Union; in REITs, Equity Office Properties (EOP) bought Speiker Properties. The past couple of months, however, have seen a number of headline-grabbing deals, most notably Amgen's (AMGN) bid for Immunex (IMNX), Hewlett-Packard's (HWP) plan to merge with Compaq (CPQ), and satellite TV firm Echostar's (DISH) bid for Hughes Electronics (GMH). But none of these is a done deal by any means: Shareholder opposition to the HP-Compaq merger has been mounting, while Echostar-Hughes faces tough regulatory scrutiny.

Meltdowns
Unfortunately, corporate meltdowns were far more numerous in 2001 than megadeals, as an astonishing array of once-prominent companies filed for bankruptcy. Enron's (ENE) recent fall from grace got the most press, which isn't surprising given that it was the biggest bankruptcy filing by far in U.S. history. The bursting of the dot-com bubble also claimed many victims, perhaps the most prominent being Internet grocer Webvan, which went belly-up in June. Among the other well known companies to file for bankruptcy in 2001 were tech consultant Marchfirst, tech service firm Comdisco (CDO), and camera maker Polaroid.

The worst damage, however, came in the telecommunications industry. Telecom firms had borrowed billions of dollars in 1999 and 2000 to build networks capable of handling high-speed data traffic, based on the assumption that consumers would flock to these networks like flies to honey. When demand turned out to be a small fraction of what the industry had expected, telecom firms were left saddled with crushing amounts of debt but no revenue to pay it off. The result was a flurry of bankruptcies in 2001 for companies that had boasted multibillion-dollar market caps just a couple of years before. These bankrupt telecom firms included ExciteAtHome; PSINet (PSIXQ); Exodus Communications (EXDSQ); 360Networks (TSIXQ); digital subscriber line (DSL) firms Covad (COVD), Rhythms NetConnections, and Northpoint; and fixed-wireless firms Teligent (TGNTQ) and Winstar (WCIIQ). Many other smaller telecom companies are teetering on the brink of bankruptcy, and even giant AT&T (T) is planning to break itself up into parts after an ill-fated venture into cable.

Plenty of companies went through tough times in 2001 without falling so far as bankruptcy. For example, the recession caused loan defaults to soar, which hurt a variety of financial firms. Credit-card issuers Providian (PVN) and NextCard (NXCD) both saw their stocks collapse because of spiraling bad debts; large banks such as Bank One (ONE) and Bank of America (BAC) also saw a spike in bad debt, but were better able to handle the problems because of their size. Among pharmaceuticals, Merck (MRK) disappointed investors in December by warning that eroding margins and generic competition will keep earnings flat for 2002, followed by a similar announcement from Bristol-Myers Squibb (BMY). These announcements made it clear that pharmaceutical stocks can't necessarily be counted on to generate double-digit earnings growth year after year, as they have in the past.

September 11
Ultimately, the problems of these industries are insignificant compared to the devastation wrought by terrorists on September 11. The attacks closed the New York Stock Exchange for four days, the longest such shutdown since World War I, but the effects went far beyond the financial markets. The shutdown of the U.S. airline system after the attacks--and the subsequent drop-off in air travel due to terrorism fears--was a crippling blow to the airline industry. UAL (UAL) and AMR (AMR) dropped more than 40% when the markets reopened, and many airlines are in precarious financial shape despite massive layoffs and a government bailout. Travel-related industries such as hotels (e.g. Marriott (MAR)), cruise ships (e.g. Carnival (CCL)), and online travel (e.g. Expedia (EXPE)) have also suffered, though these stocks have regained many of their initial losses after travel declines turned out not to be as steep as some feared.

The broader economic fallout from the attacks extended far beyond the travel industry. The automakers, already hurt by a weakening economy, offered huge rebates and rock-bottom financing to keep people buying cars, and the result was heavy third-quarter losses by Ford (F) and the U.S. operations of DaimlerChrysler (DCX). Other cyclical firms have been hurt to varying degrees by a general decline in spending by both consumers and corporations. On the other hand, defense stocks have received a big boost from the prospect of increased U.S. military spending for the war on terrorism. Northrop-Grumman (NOC) and Lockheed Martin (LMT) both jumped 15% immediately after the attacks, and have held on to those gains since then.

As many pundits have already noted, the world is a very different place than it was before September 11, 2001, and many of the changes are likely to be permanent. Investors have been through a lot in the past year, but through it all, the stock market has proven remarkably resilient. Whatever ups and downs may come in 2002, it's clear that the fundamental principles of investing haven't changed. Investors who kept their eye on undervalued stocks and companies with strong fundamentals have ultimately been rewarded, and that pattern isn't going to change any time soon.