Let's say someone told you last year that stocks would make a roaring comeback in the first half of 2003 and that we would find ourselves in a bull market, with returns zooming 20% or more. Most likely, you would have thought: "Yeah, and the tooth fairy is real -- and Elvis lives." Yet this hot market is looking more authentic than one of those prime-time TV reality shows: The Standard & Poor's (MHP ) 500-stock index is up about 15% so far this year, with most of the gains coming since the market lows of Mar. 11. Since then, the S&P has jumped 26%, the Dow Jones industrial average 24%, and the Nasdaq Composite Index 31%.
Now, the $64,000 question (mauled down to $38,400 by the bear) is: Will stocks continue their ascent? First, the good news: It's likely the market will have a winning year for the first time in four years. That's big stuff. Stocks are once again performing after three years of the most grueling bear market since the Depression. Investors should breathe a sigh of relief when they check their portfolios at yearend, rather than reaching for the TUMS. The bullish environment could last for a year, maybe even two.
Several trends have converged to power the rally: healthier-than- expected first-quarter earnings, a quick resolution to the Iraq war, and continued interest-rate easing by the Federal Reserve. Tax cuts on capital gains and dividends have spurred the more recent gains. President Bush's $350 billion tax-cut package calls for a maximum rate until 2009 of 15% on stock dividends and capital gains on assets held more than a year.
All of this has egged on investors. They've poured an estimated $22 billion into U.S. equity funds since the beginning of April, according to Trim Tabs, an investment-research firm. That's after yanking out more than $11 billion from January through March. And they have changed their tactics. "Last year, investors were selling on rallies," says Francis Gannon of AIG SunAmerica Asset Management. "Now, they are holding on to ral- lies and buying into the dips."
For another strong upswing, however, the market probably needs a rest. The buying has been so strong, says Richard McCabe, chief market analyst at Merrill Lynch, that the market is technically overbought. "There are still a few flies in the ointment in the market's short-term technical picture," he says.
Indeed, the market could well consolidate and even pull back a bit during the coming weeks. For one thing, the second quarter is poised to be the weakest for corporate profits, which were hit by everything from bad weather to war. They are expected to be up just 6% year over year. There's fear of deflation, continuing bad unemployment, higher oil prices, and more terrorist attacks. Besides, the old adage "sell in May and go away" could again hold true this summer. Since 1950, stocks have eked out a 0.1% average rise from the beginning of May to the end of October but leaped by around 8% from November through April, according to the Stock Trader's Almanac.
After some consolidation, the market could well resume its rise. Many economists and strategists believe the economy is finally picking up steam. Capital spending seems to have stopped falling, and business cash flow is improving. Add to that the tax cuts and easy money pouring out from Washington that will probably pump both stocks and the economy in the runup to next year's elections. Says John Myers, president and CEO of GE Asset Management: "You've got to believe the stimulus will make for a stronger economy." And he's putting his money where his mouth is: GEAM has been fully invested in equities since the start of the year and has been raising cash by selling bonds.
Another good sign: Small-cap stocks have been stirring. The Russell 2000 small-cap index, often a leading indicator of an improving economy and market, is up 20% so far this year.
What's more, corporate earnings growth could quicken in the second half. Analysts expect profits to rise 13% in the third quarter and soar 21% in the fourth. For the year, they estimate earnings will be up by around 12.5%, says Thomson First Call. A lot of those earnings come from cost-cutting measures, such as layoffs and pay cuts, rather than higher sales. But with all the attention on accounting shenanigans and fair disclosure practices, corporate executives are talking down earnings expectations -- thus increasing the chances of positive surprises.
Finally, historical precedents are encouraging. Since 1945, sharp reversals similar to that from this year's market lows have happened about 16 times. But when they did, the market rallied 25% on average in the next 11 months, says hedge- and mutual-fund manager Martin Zweig.
By some measures, stocks are expensive. The price-earnings ratio for the S&P 500 based on 2003 estimates is about 19, well above historic averages of around 15. But higher p-e's could be justified by rock-bottom interest rates. In fact, stocks are once again an attractive alternative to bonds. With 10-year U.S. Treasury yields down to 3.1%, stocks may be more than 40% undervalued compared with bonds, say some strategists. Indeed, after the tax cuts, stocks now yield 1.4% after tax on average, vs. 1.9% on 10-year Treasuries
So is the bull back for real? Not exactly. Some experts believe we're in a bull-market phase of a longer bear market. According to James Paulsen, chief investment strategist at Wells Capital Management, the market will probably rise in the next two years, yet we are still in an extended trading range much like the '70s. Says Paulsen: "But I think the cyclical policy push is going to win for a couple of years." Besides, the economy isn't improving fast enough to produce a real bull market, he says, because consumers still have heavy debts and U.S. business faces greater global competition. For some, what's happening now is reminiscent of the 1966-82 bear market. There were six "cyclical bull" markets during that stretch, according to John Caldwell, chief equity strategist at McDonald Financial Group. "We've seen this trend repeated throughout the 20th century: The long-term trend is marked by some pretty good whipsaw action."
Part of the problem is that investors aren't yet true believers in stocks again. Although they've shifted money into equities of late, they still have some $5 trillion stashed in money market accounts. "Three years of bruising tends to leave some psychological scars," says Tobias Levkovich, equity strategist at Citigroup's Salomon Smith Barney (C ) Adds Paulsen: "When those who left the market or at least significantly pared back exposure to stocks are convinced [it's safe to come] back in, that will be the real power." That includes foreign investors. In the first quarter, foreign selling of U.S. shares reached a five-year high, says Lombard Street Research.
HOLD ON TIGHT
So what's an investor to do? It may be wise to ride this minibull. Putting money into stock indexes may give you a lift, but picking quality stocks selling at a discount to their peers and with strong earnings momentum could be a better way to maximize returns.
Finding good companies that are cheap -- value investing -- may still have a slight edge over growth investing, since growth stocks tend to do best in a hotter economy. That said, many beaten-down stocks are cheap for a reason. Some techs and telecoms, for instance, have outdated business models or are still plagued by overcapacity. Investors could be wise to take General George Patton's advice. He once quipped: "Take calculated risks. That is quite different from being rash." Sanford C. Bernstein, the independent research arm of Alliance Capital Management, recommends stocks in three different value categories: leveraged-buyout candidates, companies whose debt is junk but that have improving cash flow, and companies that sell for much less than others in the same industry.
As for growth companies, strong price momentum, upward earnings revisions, and sustainable growth are important, according to Sanford Bernstein. But, cautions J.P. Morgan's Jack Caffrey, "you can't just invest on valuation alone right now. You have to be confident in a company's ability to execute."
Energy stocks could be a good place to look. With oil at more than $31 a barrel and a natural gas shortage looming, energy companies are hot. Some experts like stocks such as ChevronTexaco (CVX ) and ConocoPhillips (COP ), which trade at relatively low p-e's. Media stocks, especially cable companies such as Cablevision Systems and Comcast (CMCSK ) could fare well.
Will tech rebound? It's certainly showing brisk signs of life. Analysts are looking for a 21% jump in second-quarter earnings from a year ago, largely because of weak comparisons, so caution is needed. Some like mid- and small-cap stocks such as Network Associates (NET ) and Avid Technology (AVID ), which could be set to take on heavyweights like Cisco Systems (CSCO ) and IBM. Despite telecom's continuing problems, it could produce some gems. Even Nortel Networks (NT ) which is focusing more on its growing optical business, may be worth a look, along with cable-telephony upstarts such as Arris Group (ARRS )
Pharmaceuticals could also get a push. Big, beaten-down Pfizer is rated a strong buy by a number of analysts because of its fuller drug pipeline after its recent merger with Pharmacia (PFE ). And smaller biotechs such as Gilead Sciences (GILD ) which has six products on the market, look promising.
Finally, don't forget dividend-paying stocks. Sure, the best ones have had a bit of a runup, but that could continue on the wings of the tax cuts. As Warren Buffett once said: "If you can eliminate the government as a 39.6% partner, then you will be much better off."
Meanwhile, don't be dismayed if a brand-new bull hasn't broken into a multiple-year run. It will happen, eventually. But when the bull comes back, it's likely to be more tame, with annual gains in the high single digits and backed by a stronger economy. The key for now is to pick the right stocks. Simple? Not quite. But BusinessWeek is here to help. At least we hope to make investing easier than an Elvis sighting.
By Marcia Vickers