By Marcia Vickers
Warren Buffett is fond of saying, "It is optimism that is the enemy of the rational buyer." Tell that to investors. Lately it seems they've been blithely jumping back into what Wall Street is calling a renewed bull market, while paying little attention to some of the market's less attractive underpinnings.
Despite a 152-point drop in the Dow Jones industrial average on May 23, there's no arguing that a pretty incredible rally has been going on. Since March 22, the Dow has soared 1716 points and approached its all-time high of 11,722. Since April 4, the Standard & Poor's 500-stock index has risen 17%, and the Nasdaq Composite Index is up 37%. What's more, small-cap and mid-cap stocks have been on a tear.
The reason for the recent runup: Investor optimism has again been unleashed. The Federal Reserve's five interest-rate cuts, although they've yet to work economic magic, have investors believing the economy is on an upward swing, and the stock market is following. Sure, it could be that the market has reignited and will soar into nosebleed territory once again. Perhaps pigs can fly, too.
ROUGH GOING. It's far more likely that the bull is just getting on its feet, coming back from 2 1/2-year lows. But there will be more rough going before the market is ready to run. Why? There's still a weak profit picture, at least until the fourth quarter, and the economy remains relatively flat to weak. In fact, it's likely the market won't stage a sustained recovery until the fourth quarter of this year or the first quarter of 2002, when profits start to pick up, in response to the Federal Reserve's aggressive rate cuts. And forget tech stocks for now--their earnings are expected to be down at least through the year's end.
Investors are underestimating a slew of economic woes. There's the energy problem, the weak euro, and a nearly $400 billion trade deficit coupled with global economic weakness. Germany and France reported gross domestic product growth of 0.4% and 0.7%, respectively, this week, well below what was anticipated. Japan's outlook is still dismal. And now that the GOP may lose control of the Senate, add political uncertainty to the mix.
Then there are earnings. Sure, some companies have been beating projections, but consider that those have been slashed to smithereens, making "coming in above expectations" about as meaningful as a buy recommendation on a dot-com stock. Through May 18, 64% of second-quarter preannouncements have been negative. That's only slightly down from the same period last quarter. "Problems on the earnings front might cause an overly optimistic market to back off soon," says William J. Meehan, Cantor Fitzgerald's chief market analyst.
In fact, the market could retreat in coming weeks and remain in a "trading range" all summer. "We'll see some giveback and testing this summer--there will be profit problems, the Japan recession, half of California blacked out again--something will happen," says Charles Pradilla, chief investment strategist at SG Cowen Securities.
Even so, there's good news in this rally. Market breadth has improved dramatically as investors take money out of tech stocks and move it to other parts of the market: consumer services, health care, financials. That makes the chance of a bull market more likely and much more sustainable when it actually resumes.
APRIL SHOWERS. Investors have also been putting new money--much of which had been parked in money market accounts--into economically sensitive Old Economy stocks. The Morgan Stanley Cyclical Index, which consists of 30 stocks, including Alcoa Inc. (AA) and Caterpillar Inc. (CAT), has outperformed the S&P by 35% over the past seven months. Even cyclical tech stocks--in semiconductor and semiconductor equipment--have been leading the recent rally.
Just because the rally may not last into summer doesn't mean we'll return to a bear market either. Most analysts say the market bottomed out in late March and early April. They're probably right. Technical indicators show that the market has finally broken through bear trend lines that have existed since September.
In order for the bull to run, however, the Fed must deliver a stronger economy and rosier profit picture. The market's not going up from here on investor optimism alone. Vickers covers markets and investments from New York.