The Case For Dow 10,000

Behind the market's rise is a still-healthy economy

Have investors gone mad? Is there anything to justify a 1700-point rise in the Dow Jones industrial average in just seven weeks? Has the economy improved that dramatically? No, it hasn't.

The real story is that, all along, the economy was a lot stronger than the pundits were telling investors. Reports of the collapse of corporate profits were greatly exaggerated. Asia and Latin America did not quite melt down. Add in a dramatIc series of interest-rate cuts--in the U.S. and other major industrial countries--and a recharged mergers-and-acquisitions boom, and you get a market driving toward Dow 10,000.

The market's muscle is astonishing, leaving many pros breathless. "People were too bearish before, so there's panic buying now," says W. Shannon Reid, a senior portfolio manager at First Capital Group in Charlotte, N.C., as he watched the Dow gain nearly 215 points on Nov. 23. "It looks like a melt-up." Indeed, the sheer momentum of the market's comebaCk has heads spinning. Ralph J. Acampora, the market technician at Prudential Securities Inc., whose bearish predictions on Aug. 4 helped slice 300 points off the Dow that day, is again in the bulls' camp. Acampora hasn't finalized his 1999 forecast yet but says firmly that the Dow will be "well above the 10,000 mark" next year.

Indeed, the market is coming around to what Abby Joseph Cohen of Goldman, Sachs & Co. has said all year: "The fundamentals of our economy are good, profits look O.K., business investment is O.K., and consumption's O.K." And with easier monetary policy, "the Fed gave us something of an insurance policy that it's monitoring the global situation. That makes everyone more comfortable." Cohen, who looked gutsy in August when she said that the Dow would finish the year at 9300, still holds to her next target: 1250 on the Standard & Poor's 500-stock index in 12 months. That's roughly equivalent to 10,000 on the Dow.

The economic picture has brightened now that the shape of the third quarter is emerging more clearly. Real growth in gross domestic product came in at a 3.9% annual rate, 1.5 percentage points better than expected, productivity growth beat all forecasts, and even the U.S. trade deficit turned out to be smaller than expected. And the fourth quarter, once forecasted to show a sharp slowdown, could come in at near 3%. "By cutting rates, the Fed is sending a message that it wants the economy to do better," says Thomas V. Reilly, chief investment officer of Global Value Group at Putnam Investments. Reilly says he sees pickups in orders at industrial companies such as 3M and at computer and semiconductor companies.

Also coming into sharper focus, as the last of the third-quarter earnings reports come in, is the realization that they were better than their headlines. Brian F. Rauscher, U.S. investment strategist at Morgan Stanley Dean Witter, says much of the disappointment in the reports were concentrated in a handful of big companies, which pulled down total earnings. General Motors Corp., which suffered the effects of a strike, was the biggest drag on the S&P 500, with a $570 million operating loss, a $1.4 billion drop from the third quarter of 1997. "That's not due to a fundamental weakness in the company, but a one-time event," says Rauscher. Take out GM, and the S&P earnings improve modestly, from -2.9% to -1.2%. Most of the other depressants came from write-offs in the financial sector and a drop in oil-company earnings in the wake of a 20% drop in oil prices.

COMMODITIES REBOUND. In short, much of the downdraft in earnings was concentrated in a few sectors; it was not a widespread affliction for Corporate America. According to Rauscher's analysis, 62% of the 476 companies that have reported their third-quarter numbers made profit gains over 1997's third quarter and 3% matched. And the median S&P 500 company recorded a nifty 9% year-over-year gain. According to Rauscher, the stage is already set for year-over-year profit gains of 3% to 5% in the fourth quarter. With some firming in energy and commodities, Rauscher thinks earnings can go up 7% to 9% next year.

Of course, a rebound in commodities is a mixed bag. Higher prices would boost the depressed energy and natural-resource companies, but lower commodity prices help the economy by keeping inflation at bay. Indeed, that's part of what's driving stocks. From Nov. 12 to Nov. 23, when the Dow gained 544 points, or 6.2%, the CRB/Bridge Futures Price Index, an amalgam of 17 commodities futures prices, dropped 4.6%.

The annual gain in inflation is now 1.5%, the lowest since the 1960s. "If you can get 5% real earnings growth when inflation is near zero, you have an attractive environment for stocks," says investment strategist Edward M. Kerschner of PaineWebber Inc. "Double-digit earnings growth invite the Fed to start raising rates."

The Fed has pushed short-term interest rates lower, and that is a powerful stimulus for stock prices. Just look at the "two tumbles and a jump" signal, an indicator developed by Norman Fosback of the Institute for Econometric Research: When either the discount rate, the banking reserve requirement, or the margin requirement are lowered twice after an increase, the market usually makes big gains.

How big? Twenty calendar days after the signal, the S&P 500 is usually up an average of 4%. (By Nov. 23, just the sixth day after the second discount rate cut, the S&P was up 4.3%). According to Fosback, the average S&P gain after three months is 11%; after six months, 15.9%, and after one year, 29.7%. Fosback says the two-tumbles signal is most effective in the six-month and yearly intervals. In 18 of 19 times, returns have been positive. Even with the signal pointing to higher stock prices, Fosback himself is bearish, mainly because of high price-earnings ratios. Still, admits Fosback, "it's tough to go up against the Fed."

THE "WALL OF WORRY." Rather than acting as a depressant, such bearish sentiment is usually a positive for stocks. Bull markets climb a wall of worry, because bad news has already been discounted, so positive developments send the market higher. There's still plenty of worry about. Asia is not yet out of the woods. Investment strategist Charles I. Clough of Merrill Lynch & Co., bearish on stocks for several years, remains unconvinced that corporate profits will rebound in coming quarters. "Consumption and investment are already well above the long-term trend, yet earnings are weak," says Clough. "With low inflation and no pricing power, how are you going to get better earnings?"

Mergers help, certainly, by allowing companies to slash overhead, build market share, and gain economies of scale. On Nov. 23 and 24 alone, deals worth $70 billion were announced, according to Securities Data Co. Still, this stock market isn't dependent on dealmeisters to keep moving up. The economy's resilience and vitality is likely to keep the market on the march to Dow 10,000.

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