It was as if the stock market was thumbing its nose at Saddam Hussein--and at the conventional wisdom that an outbreak of war would be followed by a sharp decline in equities. After an evening of air attacks on Iraq and Kuwait, the market staged a 115-point rally on Jan. 17. World bourses surged. But with the news from the gulf turning increasingly somber, investors are facing a quandary: Even if Iraq will be swiftly crushed, are there compelling reasons to buy stocks?
The answer is a qualified, unenthusiastic "yes." Oil prices have dropped resoundingly. Short-term interest rates have fallen below 7%, giving renewed allure to "defensive" high-yield stocks such as utilities. And it's also true that a short and successful war should boost consumer confidence--and quite possibly hasten an end to the recession.
But so long as Iraq remains undefeated and still can wreak havoc by lobbing Scud missiles, the market will continue to experience the kind of queasiness that has pummeled stocks in recent days (chart). "Investors are still jumpy," notes Greg Smith, chief investment strategist at Prudential-Bache Securities Inc. "Their worst fears have been erased, but there's still a lot that could go wrong. You have to be as good a military analyst and political analyst as an investment analyst these days."
'TOO EARLY.' Indeed, investors throughout the world have become devoted armchair generals recently. And in the early hours of the war, optimism was the byword. Even a missile attack on Israel and the possibility of Israeli retaliation scuttling the allied coalition, failed to cause much angst on Jan. 18. "The early optimism may not be warranted. The war is not going to end that quickly," says Michael Morizumi, an investment strategist with Lehman Brothers Japan Inc. in Tokyo. "It's a little too early to get back in the water." In Europe, where investors are troubled by Soviet actions in the Baltic states, caution prevails. Notes Angus McNeilage, chief of European equity sales with James Capel & Co. in London: "People are sitting and awaiting events to unfold."
But in contrast to the aftermath of the invasion of Kuwait on Aug. 2, the specter of inflation has been quelled, and U. S. market fundamentals are considerably more upbeat. "After a few weeks of sifting through the war news, the market will go back to trading" on factors such as earnings, predicts
Steven A. Kroll, president of Shearson Lehman Advisors.
Among the fundamentals driving the market, none gives greater cheer than energy prices. Oil prices have fallen to their lowest level since the gulf crisis began, and that has lowered inflationary expectations and sparked a rally in the bond market. Meanwhile, investors have turned sour on energy stocks, which blossomed when the crisis started. Analysts are optimistic that oil prices will remain depressed, keeping inflation in check and benefiting heavy energy users such as transportation companies--so long as the Saudi oil fields remain out of harm's way. "Oil in the mid- to high teens is likely, given energy fundamentals," notes Stuart Sedlacek, an analyst with IDS Financial Services Inc.
PORTFOLIO DEFENSE. Some high-profile stocks have been boosted by nifty earnings surprises. Among them were a roster of technology companies, such as IBM and Digital Equipment, which had been out of favor, and software giant Microsoft. But skeptics say earnings disappointments are still rife--and will continue to depress stock prices now that the recession is under way. Indeed, some bears predict that the market will fall below its October low of 2365. "We've never had a bear market accompanied by a recession that was over in less than 14 months," says Carmine Grigoli, stock market strategist at First Boston Corp. By this school of thought, the bear market is but six months old if measured from its peak in July.
Yet the recession, which is pushing up unemployment and bankruptcies, does bring one positive to the stock market: lower interest rates. Long-term rates, which spiked upward before the outbreak of the war, have fallen back. Short-term rates are in a tailspin as the Federal Reserve floods the financial system with liquidity to fight the recession. In recent weeks, bank liquidity grew at a rate not seen since 1984--just months before a sustained market surge--notes Charles I. Clough Jr., Merrill Lynch & Co.'s chief investment strategist. Though the banks have been slow to lend, he contends that money will soon be flowing and should bolster stocks and the economy.
Even if the decline in short-term rates were to stop, as some analysts are forecasting, rates have already fallen far enough to make some equities attractive. For instance, Standard & Poor's electric power index yields 7%--higher than Treasury bills and many money-market funds. And electric utility stocks--what many investors use to "defend" their portfolios from a recession--hold out the potential for higher dividends and capital appreciation, which money-market funds do not.
In a low-interest-rate environment, portfolio managers want to own stocks of companies that are interest-rate sensitive, such as homebuilders and financial companies with solid balance sheets. "The weaker the economy gets, the more rates will come down, giving these companies a boost," says George A. Vanderheiden, who manages three Fidelity mutual funds. One of his favorites is Federal National Mortgage Assn. At Union Bank of Switzerland (UBS), Thomas Lips, who is head of investment research, is fond of such blue-chip stocks as Merck, McDonald's, Borden, and the insurance giant American International Group.
CABLE AND CELLULAR. While many Wall Street pros now think leverage is a dirty word, Vanderheiden invests in companies with leveraged balanced sheets--so long as the companies have floating-rate debt with interest payments tied to short-term rates. As rates decline, so do their financing costs. Among the stocks in this category are cable-television and cellular-telephone companies, airlines, and two prominent defense contractors--Loral and Raytheon. The latter makes the Patriot antimissile system, which has gained fame in the skies over Saudi Arabia. Raytheon shares have risen 10% since the war began.
So long as the war casts a pall over the market, stock-picking will require patience and careful selection of targets. And, as in the Persian Gulf war, final victory is likely to come only when the Butcher of Baghdad is soundly trounced.