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Gearing up for the second half
Everybody knows valuations are getting stretched -- but that's only part of the equation.
July 1, 2003: 2:46 PM EDT
By Adam Lashinsky, CNN/Money Contributing Columnist

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PALO ALTO, Calif. (CNN/Money) - Perusing the headlines, you'd think we were in a time of obvious economic and stock-market expansion. Nothing's obvious, though, these days.

So let's try to parse some of the news from a slow news day to see where it's all heading.

The big news, of course, is one of those non-news items the investment community loves: The S&P 500 on Monday finished its best quarter since 1998, a 15 percent gain in one quarter.

As Fortune's Andy Serwer wrote Monday in his Street Life column for CNN/Money, "Get your 401(k) statement in the mail, and OPEN IT!"

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Good idea, Andy. Don't get too carried away, though. Even with the S&P's strong showing, you indexers of various flavors now are back to late 1997 levels and are underwater on investments made before this past quarter. But, hey, it's certainly a start.

What's next?

What you really want to know, of course, is where it's going. A source of mine who's habitually close to hedge fund managers predicts that hedge funds are entering their most difficult month in years.

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"For the first time in a while, they've got to earn their money," this source says, because the direction isn't clear. Everyone instinctively knows stocks have outgrown valuations too quickly, especially in technology. And yet, higher valuations can be self-fulfilling prophecies.

There are plenty of examples of how this momentum can work.

Take Veritas, which completed its acquisition Monday of Precise Software, a small Massachusetts-based company that makes software used by businesses that want to measure how well all their various applications are working.

This deal is the opposite of the goings-on between Oracle and PeopleSoft. To be precise, it's friendly, and the two companies already had begun working together before the deal closed.

What's more, Veritas is paying a boatload of money, $609 million, or about eight times Precise's 2002 sales, about two thirds of the total in cash.

Precise is profitable, but it's growth has been slowing, making it a perfect acquisition target. (And acquisitions can wring out costs, making more money on declining revenues.) The rich multiple Veritas is paying turns out to be not much more than what public shareholders are paying for Veritas.

So as was the case before the bubble burst, rich valuations tend to feed on each other, and so on.

In an another instance of self-fulfillment, the weak get stronger in this environment precisely because there's so much optimism.

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Level 3, the telecommunications carrier that swooned before Warren Buffett and Bill Miller rode to the rescue, raised another $250 million Monday in low-coupon-value convertible notes. (That means the company doesn't pay much interest to its note holders, relative to, say, junk bond holders.)

If Level 3 can continue to replace expensive debt with less expensive debt and if -- the bigger if -- it can grow its business, it just might defy the naysayers and survive.

Most pundits predict a correction of some sort in the next few weeks. Even more forecast a slow week as the smart pros clear out for the long weekend.

If only the economy would do something, anything, imagine what this rally really could accomplish.

Adam Lashinsky is a senior writer for Fortune magazine. Send e-mail to Adam at

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