Why The Rally In Stocks Could Have Legsby
In the topsy-turvy world of stock-market indicators, excessive optimism is as welcome as a stake through the heart. Widespread hopelessness, on the other hand, is a contrarian sign of better times ahead. So when stocks climbed to record highs on Mar. 8 and 10, the angst on Wall Street was almost palpable. Oh dear, have things gotten too good?
In fact, this seems to be one of those times when a market record is an occasion for celebration, not mourning. In all likelihood, the current rally has a ways to go before it stalls. True, much of the momentum is caused by an onrush of cash from institutional investors and mutual funds, reacting to the plunge in interest rates--an infusion of capital that could easily reverse if rates climb. But so long as rates are steady or declining--and chances favor that--the case for stocks will remain unshaken. "The bond market has been very strong, and bonds usually lead the stock market by three to six months," observes Robert B. Ritter, director of research at Ladenburg, Thalmann & Co.
RATES RATE. One source of reassurance is that the market rally is broad-based. Small-capitalization stocks, which were trounced in the sell-off that followed initial reaction to President Clinton's economic plan on Feb. 15, have climbed back. But the rally has been equally vibrant in the larger stocks, such as the components of the Dow Jones industrial average and the Standard & Poor's 500-stock index (charts). And the reason for the rally pretty much boils down to one thing: rates. With 30-year Treasuries yielding 6.8%, money is pouring into bonds on the theory that rates will fall still further. Money is also pouring into stocks on the theory that bond rates are too low. "The bond market has been a self-feeding, self-propelling influence," notes Eric T. Miller, chief market strategist at Donaldson, Lufkin & Jenrette Securities Corp.
Declining rates have forced analysts to rejigger their market-valuation models--for the better. Shearson Lehman Brothers strategist Elaine M. Garzarelli reckons that, as a result of the rate decline, a fair price-earnings multiple for the S&P index would be 17.6. When that is multiplied by estimated 1993 earnings of $28.50, the S&P's fair value is 502. Since it's now 455 or so, the market has about 10% to go--by that reckoning. If 1994 earnings are factored in, the fair value would be 537, or 18% higher.
That, at least, is the theory. And as money streams into the market, the bullish case is becoming a self-fulfilling prophecy. The market is liquid as never before: There's a tidal wave of cash that dwarfs even the headiest days of the 1980s. Much of it comes from pension funds that simply cannot meet their total-return assumptions by buying bonds that yield less than 7%. Up through early March, equity funds took in $24 billion in investor cash--70% more than the $14 billion realized a year ago, notes Robert Adler, who heads AMG Data Services, which tracks inflows to mutual funds. That has given funds a mammoth hoard of cash to invest in stocks. Such cash flows are gauged by dividing fund cash positions into the value gf total trading volume. Normally, the funds have cash equal to 6.0 days of volume. Laszlo Birinyi, head of the Birinyi Associates research boutique, notes that funds now have enough to buy 6.7 days worth of trading. That's close to the all-time high of 7.2.
Where is all this cash likely to wind up? Ritter expects that investor cash will pour into a wide swath of economically sensitive "Clinton stocks"--rate-driven financial and utility stocks, as well as some cyclicals and stocks likely to benefit from protectionism, such as autos and semiconductors. Garzarelli is also advising investors to play the market through cyclicals, especially technology. She also likes steel, autos, building materials, and homebuilding stocks.
TAILSPIN? True, the picture is not entirely free of clouds. Skeptics argue that a liquidity-driven market is an inherently shaky market. E. Michael Metz, a market strategist at Oppenheimer & Co., believes that the market is fully valued and that a change in investor psychology, perhaps caused by an upturn in rates, could send it into a tailspin.
Metz recommends that investors keep a high cash position--and he is not alone. Ritter notes that one survey shows market technicians recommending that investors cut their equity exposure from 66% to 50%. At Smith Barney, Harris Upham & Co., options-and-futures whiz Timothy C. Ng notes that institutional investors are hedging their portfolios by buying "put" options hand over fist. That has driven up the price of puts, which rise when share prices fall. Such nervousness is, of course, bullish. Only when the ranks of the bears thin out is it time to head for the cave.