The dawn of the new decade is starting to offer so many parallels to the beginning of the last decade it's downright frightening. A statistically mild, psychologically painful recession, a military engagement in the Middle East, a Bush in the White House. But this time it's different in many ways. This Bush is in touch with the economy and responding to it and this Middle East engagement hit home a whole lot harder than the Persian Gulf War.

The devastating terrorist attacks of September 11 scarred the national psyche in a way that no other event, not even the attack on Pearl Harbor,ever did. By early October, the United States appeared to be making impressive progress in terms of healing its psychological wounds, even if all the ramifications have yet to play out. It's become painfully clear that even if it's possible to neutralize terrorism, it's probably impossible to eradicate it entirely.

The realization that our security has been compromised is likely to cast a specter over the economy and the financial markets for some time to come, even as the healing process gathers momentum. Terrorism may not be able to inflict a permanent wound on the American economy, but it has derailed several phenomena of the 1990s, including full employment, the inexorable move towards globalization and advances like just-in-time inventory management.

Despite dubious pleas by Richard Grasso, president of the New York Stock Exchange, and others for Americans to demonstrate their patriotism by buying stocks when the markets reopened on September 11, many failed to comply. Instead, more Americans opted to show their concern and patriotism in nobler ways, as a wave of charitable giving that seemed far more appropriate to the circumstances occurred spontaneously.

The absurdity of the calls for Americans to buy stocks and go shopping at a moment of great national tragedy did a lot to place the whole insane stock market culture of the 1990s into proper perspective. Bill Gross, chief investment officer at PIMCO, penned a brilliant piece, admitting that he had done his fair share to support that culture. He also recalled the days when his parents and their friends bought savings stamps at 10 cents apiece to give Uncle Sam "a little more money to fight Hitler."

"Now, instead of savings bonds, we equate patriotism with supporting the price of Cisco at $14 a share and making sure the malls are filled with shoppers pushing each other aside in order to purchase the newest upgrade of Nintendo," Gross wrote. "Strange, isn't it-how we've changed, what we consider to be important, how dependent we've become on consumerism and the market." By the end of September, Americans were a lot less concerned with their portfolios and their possessions than they were with basic necessities like security.

We may not have the sense of security we once did, but America does have markets that are free to express whatever they want to express. The big sell-off during the week of September 17 was triggered by institutional investors and other so-called professionals. Retail investors remained paralyzed for weeks, according to Steve Leuthold, head of The Leuthold Group in Minneapolis. "The preliminary results are that there were $23 billion in mutual fund redemptions in September, which sounds larger than it is," he explains. That represented less than 1% of equity fund assets, compared to the 3% of stock fund assets that were redeemed in October 1987.

In the weeks after September 11, equity prices swooned to levels that caught the attention of some outspoken bears. "My view is that the drop we've had so far had made our own near-term outlook relatively bullish," notes Rob Arnott of First Quadrant Advisors, which manages $16 billion for 78 institutional clients. "Stocks are still pricey, but they are attractive on a tactical basis."

Arnott doesn't expect equities to return more than 5% or 6% a year for the remainder of the decade, reasoning that the bull market between 1982 and 1999 was so powerful and unsustainable that it borrowed from future returns for years to come. The bear market of the last 18 months has only enjoyed marginal success reducing many long-term structural problems afflicting the U.S. stock market. "Yields are under 2%, growth prospects are not that brilliant, and the New Paradigm crows is very quiet," he says. "But I think the market will be higher at year-end and if people have modest expectations they'll do all right."

After suffering its worst week in 60 years when it reopened on September 17, markets recovered swiftly. Leuthold believes the downdraft was caused by institutional selling and the recovery fueled by hedge fund short covering. A flight to quality buoyed large-cap stocks, disguising a reversal of leadership that has been under way for two years. Leuthold continues to favor small-cap and mid-cap stocks, explaining that the average stock was selling at 14 times normalized earnings in early October, compared with the Standard & Poor's 500 Index, which was trading at 19 times normalized earnings. (He favors normalizing earnings because at one point in the 1990-91 era, the Dow Jones Industrials Average sold at 100 times, thanks to huge writedowns.)

Despite outperforming their blue-chip brethren since mid-1999, small-cap and mid-cap stocks still sell at a 30% discount to them. "The typical period of small-cap and mid-cap outperformance has been four years, and we're two years into it," Leuthold notes. "Believe it or not, there have been times when these asset classes sold at a premium to large-cap stocks."

Like more than a few money managers, Leuthold is starting to find technology stocks intriguing, partly because it's hard to see how things can get much worse. "We think this may be a fertile hunting ground," he says. "This is a time to look across the valley."

Equities may be reasonably priced now, but there are myriad good reasons why they should be. Insurance companies are chasing airlines right up the steps of Capitol Hill in search of a bailout in a spectacle not witnessed for 20 years. What's next, hotels?

In late 2000 and early 2001, many professional investors and academics were noting that the equity risk premium, the return on stocks minus the return on risk-free securities (Treasury bills), had fallen to zero, if not to negative numbers. "The equity risk premium is now rising, due to uncertainty," says Len Darling, chief investment officer at OppenheimerFunds. "Some work shows it's back to 3.5%, or where it was in 1996 before the bubble was in full force. It has been higher in the past, and it likely could go higher in the future."

Darling says that in late September, Oppenheimer was reacting to the market decline by moving out of safe stocks like utilities and into small-cap and high-beta stocks. "The fundamentals argue for the market to be underpriced," Darling says, when asked about a Wall Street Journal article by Princeton University's Burton Malkiel claiming the market's price/earnings multiple should be around 22, in light of low inflation and interest rates. "The market has quickly adjusted to new factors and repriced itself. Both growth and value are within a half a standard deviation of normal. But I wouldn't want to bet on the market right now as I would bet on certain companies. The markets should look better a year out."

Business activity came to a screeching halt in September, but there is a silver lining for the economy going forward. "Technology companies will get a good bump because they typically do a great deal of their business in the last two weeks of each quarter," notes John Laupheimer, manager of MFS' Massachusetts Investors Trust, adding that this didn't happen in the final weeks of the third quarter.

Across a spectrum of different industries beyond technology, the collapse of business in mid-September should create pent-up demand in subsequent quarters. This is one reason why many economists like Stephen Roach of Morgan Stanley are changing their outlook from a U-shaped recovery to a more V-shaped recovery. The "psychological blow" of September 11 to consumers guaranteed a recession and the steep decline in this sector of the economy, which accounts for two-thirds of gross domestic product (GDP), is likely to be followed by a sharp upswing at some point. The fiscal stimulus package, equivalent to about 1% of GDP, should start to kick in soon. What leaves Roach disconcerted is that, while one expects the United States as the world's lone superpower to lead the military effort to expunge terrorism, the burden of jumpstarting a faltering global economy is falling on our shoulders as well.

"I think we'll be surprised that economic activity comes back more than some people expect," Laupheimer says. In early October, Laupheimer was beginning to move his portfolio out of defensive stocks like consumer staples and pharmaceuticals into more economically sensitive stocks. "The question is when and how fast to get off the defensive," he says, acknowledging the strategy helped him this year. "We're not Japan, and we won't live in this environment forever."

Equities have another big ace in the hole at present. "The Fed is making the safe bet of money market funds pretty unattractive," notes Bill Friess, manager of the Thornburgh Global Value Fund. He spent late September purchasing shares of Pfizer, Siebel Systems, Raytheon, Lockheed and beaten-up telecom stocks like Sprint PCS.

Like many others, Friess thinks that the bubble's expectations, which stayed alive long after the bubble itself burst, finally have been shattered. "I think people will be real happy with 5% or 6% a year in stocks," Friess predicts. If he's right, they might even get 7% a year.