Why The Bull Still Has Running Room

It's at least three weeks before Corporate America starts swamping the newswires with quarterly earnings reports, but already there's a growing uneasiness in the air. On Sept. 13, IBM, the stock market's comeback kid, told Wall Street analysts that its third-quarter profit forecasts were too high. During the following days, other high-profile technology companies such as Apple Computer Inc. and Oracle Corp. also deflated expectations. It's not just technology. Caterpillar Inc., an old-line industrial giant turned tough world-class competitor, reported on Sept. 19 that earnings would fall below year-ago levels.

The four stocks went pffft, though IBM has since recovered somewhat. But together, the unexpected bulletins delivered a little kidney punch to the raging bull market. After inching above 4800 on Sept. 14, the Dow industrial average declined for three days, but came roaring back to close at 4793 on Sept. 20.

DOUBLE DIGITS. For now, the market's willing to blow off some bad earnings news. Cash continues to pour into mutual funds at a torrid pace, and the stronger dollar is luring foreign investors to the U.S. market for the first time in years. Wall Street analysts, moreover, still are forecasting hefty double-digit profit gains for the third quarter vs. the same period of 1994. Says Charles G. Crane, director of research at money-manager Spears, Benzak, Solomon & Farrell: "We're not expecting any dramatic earnings disappointment during this period."

Indeed, nearly all the major market indexes continue to trade near or at all-time highs. And despite some troubles in tech-land, the Pacific Stock Exchange Technology Index is also at a high. But moving the averages much higher won't be so easy. Profits, one of the driving forces in this bull market, are losing some of their powerful momentum.

Corporate America as a whole has beaten Wall Street analysts' earnings forecasts for the last nine quarters in a row. Now, Benjamin L. Zacks of Zacks Investment Research thinks companies on average will meet analysts' third-quarter forecast of 17.5% profit growth, "but fewer companies will beat the expectations, and those that beat them will do so by slimmer margins." The bottom line on bottom lines: Earnings will rise again, but at a slower rate.

"INFLECTION POINT." While not a sell signal per se, the deceleration is a reminder of the advanced age of the bull market and the economic expansion upon which it is built. "We're at the inflection point going from a period of very powerful earnings momentum to a lot trickier period of earnings gains," says Richard B. Hoey, portfolio manager of the Dreyfus Growth & Income Fund. "Profits are already at a high level, the economy is past the period of strong growth, and it's going to be difficult to show big earnings growth from here on out."

That's part of the problem with Caterpillar, which must cut back production because of slowing sales and higher inventories. Other companies are being hurt by the strengthening dollar, whose weakness long bolstered profits by making U.S. exports cheaper and by boosting earnings of overseas subsidiaries when translated back into dollars. On Sept. 19, Polaroid Corp. revised its profit forecast downward, in part because the rising dollar cut the value of its overseas profits.

Even if third-quarter profits pale a bit, though, the stock market is not in any great danger. Inflation is tepid and long-term rates are down--and could head lower. The market remains supremely liquid, and many investors have not given up hope for another cut in short-term rates from the Fed--if not at the Sept. 26 meeting, then at the next one. That would keep stock prices aloft.

Even at current rates, stocks are not overpriced. Stanley Levine, quantitative research director for First Call Corp., figures stocks are still about 11% undervalued based on earnings estimates and interest rates. There's still plenty of margin before stocks become more expensive than bonds, even if the market takes a few more kidney punches.

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