There's nothing like a drop in energy prices and a perceived halt in interest-rate hikes to get the market psyched again. Leading the way: The 30-stock Dow Jones industrial average, which finished the Sept. 27 session at 11,689.24—just 33.74 points away from its best-ever close of 11,722.98 on Jan. 14, 2000. The market's advance has some experts talking about the "wealth effect" again. "People are getting excited again that this will put cash in consumers' pockets for early fall, boosting consumption," says Ian Shepherdson, chief economist with High Frequency Economics.
The milestone performance by the Dow could have some momentum behind it. The markets got a kick-start on Sept. 20 after the Federal Reserve, which had increased interest rates for 17 consecutive quarters since June, 2004, decided to keep rates steady at 5.25%. That's usually a good sign for stocks: For the last six times the Fed has gone on hold, stocks were higher during the 12 months following the halt than they were in the previous 12-month period when rates were rising.
"What's more important than the new high is that the terrible fears we had in the middle of the summer, when stocks were selling off, were erroneous," says Michael Williams, an investment strategist with New York's Tocqueville Asset Management, which manages $5.4 billion. "The market is telling you something much stronger than 95% of what the headlines would suggest."
TREND-SPOTTING. Market historian and money manager Curtis Teberg of the tiny $34 million Teberg Fund in Duluth, Minn., says that in midterm election years (as 2006 is), all three major indexes (the Dow, the Standard & Poor's, and the Nasdaq) have posted positive fourth-quarter gains 100% of the time since 1986. Plus, the fourth quarter has historically been a very good period, with an average return of 5.4%. Since 1986, the Dow has produced positive fourth-quarter returns in 19 out of 20 years.
Moreover, Teberg has found that in six midterm election cycles since 1982, the low point of the Dow to the high point the following year registered an average gain of more 53% for the Dow. "Since I don't know what the low point is this year, I picked the lowest point that it has been so far, which is 10,706 on June 13," says Teberg. So what does that mean? Teberg says a 16,000 Dow in 2007, a 53% jump by next year. Teberg has also studied the results going as far back as 1926 and his research shows the trend sticks: "It has historically been a great period of time."
It may be difficult to find someone equally as bullish, but it's clear that the new upbeat sentiment on the Street is a far cry from the doom-and-gloom outlook of summer. Concerns about higher energy costs, an overburdened consumer, and a housing slump have weighed heavily on the markets. With the financial well-being of free-spending Americans in question, so was the direction of U.S. equities. "A certain amount of pessimism had set in," admits Brian Gendreau, an investment strategist at ING Investment Management in New York, which manages more than $400 billion worldwide.
"MISSING THE BOAT." Peter Morici, a professor at the University of Maryland School of Business and former chief economist at the U.S. International Trade Commission, thinks that while third-quarter earnings results may disappoint the market (because the benefit of gas prices hasn't filtered through to Corporate America's bottom line), "the fourth quarter should prove a winner. The economy will bounce sooner than many forecasters anticipate."
Fear of an inevitable downturn has kept many investors on the sidelines this year. "There is some point at which the pace of growth slows, but in the meantime the crowd is still, sadly, missing the boat," Tocqueville's Williams says. "Corporate balance sheets are more pristine than ever. Earnings are doing well, and the cataclysmic forces of $78 crude oil didn't have an impact" he notes.
Williams says that while the S&P has posted 18 consecutive quarters of double-digit profits, there's no reason to believe that earnings are going to fall off the cliff anytime soon. He recommends full-fledged buying in growth stocks and technology, such as Microsoft (MSFT), Oracle (ORCL), Cisco (CSCO), Intel (INTC), and Applied Materials (AMAT). He's also bullish on Phelps Dodge (PD), Boeing (BA), and Merck (MRK).
Another sign of a market turn: For the first time this year and since Aug. 31, higher-octane growth stocks have outperformed more conservative value stocks. Strategists see technology, telecom, and health care as potential buy targets, while financials and utilities should underperform. Ed Yardeni, chief investment strategist of Oak Associates, says the blue-chip stalwarts of the Dow are a good bet, too, although he believes that falling oil prices will spark a market rally that "could be very broad". In January, Yardeni predicted that the Dow would hit 12,000 by yearend. As the markets got progressively rockier, he "twitched" a few times, "but I never flinched."
CURB YOUR ENTHUSIASM. Yardeni says that Dow components are "very successful in increasing productivity and are basically diversified portfolios of global business. They are projecting that more than half of their business will be overseas, and I think that the earnings story has been very strong." Indeed, most Dow stocks have been earning great profits in the past several years, but their stock prices have been stagnant. The results in 2006 have been no exception: For the second quarter, all but two—3M (MMM) and Home Depot (HD)—beat Wall Street's estimates. Another two, Wal-Mart (WMT) and General Electric (GE), matched analyst estimates. Yet of those stocks that beat their earnings estimates, 13 saw declines in their stock the day the earnings releases hit the wires.
Another plus: U.S. stocks are cheap. The price-earnings ratio of the Standard & Poor's 500-stock index based on consensus earnings for 2007 is 15.4 (17.6 based on 2006 estimates). Compare that with the late 1990s, when p-e's were running in the 30s.
Even so, there are those big-picture types who are keeping the recent gains in perspective. "It's late-cycle exuberance—gas prices are down, the Fed is done, and it's hooray," says High Frequency Economics' Shepherdson. "But I'm nervous that the market is glossing over the reasons the Fed is finished with the fed hikes. The economy is slowing." Moderating productivity growth and higher labor costs are a "toxic combination" that is "disastrous for earnings," says Shepherdson, and he fears that trend will intensify. "Wage pressure will continue for the next three or four quarters, and I am very nervous as we get into next year we'll see a significant impact on earnings."
NOT MUCH BREADTH. Also in the bearish camp is Joe Battipaglia, chief investment officer of Ryan Beck & Co.: "We're in the late stages of an economic expansion. The components of profitability…have come from cyclical sectors (such as) energy, metals, and mining, along with an outsize performance by big-cap banks. Both of those groups are going to struggle. We're flirting with highs now, but it's more of a private party."
Indeed, the recent gains have been fairly narrow. Bob Dickey, a technical research analyst with RBC Dain Rauscher, notes that throughout the rally of the past two months, only about 60% of stocks are trading higher than their 200-day moving averages. "The normal reading for a more powerful bull market is 75%-80%," he writes in an e-mail. He says that gains in tech and other areas are offsetting poorly performing stocks and netting an overall gain for the broader market.
Dickey adds: "Our sense is that the current rally will carry up to near DJIA 12,000 before the market correction risk increases to a meaningful level."