Bulls See Plenty To Bellow About

As inflation worries recede, small investors resume buying

Just two months ago, the stock market was on the ropes. Bears were warning of a major correction. Technology stocks were in the tank. Individual investors were pulling money out of mutual funds. But instead of being felled by a knockout punch, the stock market is fighting back to new highs. Since tumbling as much as 383 points in July, the Dow Jones industrial average has rocketed back 530 points, and it is up about 760 points, or almost 15%, for the year so far.

What inspired the snapback? For months now, the market has been fearful that the Federal Reserve, hell-bent on warding off inflation, would raise interest rates sharply to put the brakes on an overheating economy. But on Thursday, Sept. 12, the producer price index's core rate showed a decline of 0.1% in August. The next day, inflation fears faded further: A niggardly 0.1% rise in the consumer price index and a slacking off in retail sales indicated almost no inflation--and an economy that was strong but moderating. That's one powerful economic cocktail. "This is the best profits, inflation, and productivity cycle in the U.S. in 30 years," says Jeffrey M. Applegate, chief investment strategist at Lehman Brothers Inc. "It's a central banker's dream."

"SIT THIS ONE OUT." Call it the Greenspan market. The Fed chairman has been fending off inflation hawks for months, trying to hold the line on interest rates while inflation cooled. But until a week or so ago, the question was not whether Alan Greenspan would raise interest rates when the policymaking Federal Reserve Open Market Committee met on Sept. 24, but how big the hike would be. Now, some strategists feel there's a chance that Greenspan may hold off on raising interest rates. "Given half a chance, I bet the Fed would like to sit this one out," says Alfred Goldman, director of market analysis at A.G. Edwards & Sons Inc. in St. Louis. Another possibility: Greenspan will raise rates to placate Fed hawks--but by only one-quarter of a point.

Can the rally last? Yes, says Abby Joseph Cohen, investment strategist at Goldman, Sachs & Co. In the past three quarters, profits for companies in the Standard & Poor's 500-stock index have been increasing at an annualized rate of 10%, and Cohen expects this pace to continue for another couple of quarters. Sure, earnings growth is slowing from last year's torrid pace of 20%. But in an economy where inflation is close to nil, profit growth of 10% is still a strong performance.

Applegate thinks the market has already factored an earnings slowdown into prices. "Part of the reason for the decline this summer was the market coming to grips and repricing stocks for slowing earnings growth," he says. That makes Applegate comfortable raising his yearend target for the S&P 500 from 680--which it hit on Sept. 13--to 710, and up to 780 for 1997. That works out to about 6100 for the Dow at yearend and 6700 by the end of 1997.

But the bears are still prowling around, predicting as much as a 1,000-point drop in the Dow. Rather than painting the advance as a new leg of a bull market, bears such as Morgan Stanley & Co.'s U.S. investment strategist Byron R. Wien label it part of a "prolonged topping process" and cast a worried eye on possible wage inflation (box).

PILING BACK IN. Small investors are casting their lot with the bulls. According to AMG Data Services, an Arcata (Calif.) research firm that tracks money moving into mutual funds, flows into stock funds revived to a rate of more than $3.5 billion a week for the week ending Sept. 11. That's a big jump from the last week of July, when fund flows dropped to $490 million, and it was the biggest week since the end of June. "The mood remains one in which people want to own stocks," says A.G. Edwards' Goldman. "The bears seem to ignore that."

Pressure on mutual-fund managers to invest their newfound cash could drive the market higher. Stocks will also benefit from the short list of initial public offerings. "The IPO calendar is not competing that much with the secondary market, and the cash has to go into existing stocks," says Smith Barney Inc. portfolio strategist A. Marshall Acuff. "Since this is happening before the quarter is ending, all these things are feeding in together."

Big investors who had been sitting on the sidelines are also piling back in. The memory of the July rout, when one out ef every five NASDAQ stocks fell 50% from its 1996 highs, drove some institutional investors out of the markets, says Robert J. Farrell, senior investment adviser at Merrill Lynch & Co. "There's not a lot of conviction about the direction of interest rates, or whether the economy is getting stronger or weaker, so professionals have been holding money back, up until recently," he says. Farrell says this new infusion of cash bodes well for stocks in the short term.

The kicker to this market may be the tech stocks. While highly speculative tech issues may be shunned for a while, the blue chips in the group are breaking new ground. Large-capitalization computer stocks, which had already been trending up, got a big boost on Sept. 13, when Soundview Financial Group said tech shares could rise 30% to 40% over the next four to five months. Big movers hitting new highs in recent days include Oracle, at 43 3/8; Intel, at 95 5/8; Dell Computer, at 80 5/8; and Microsoft, at 136 1/2. The runup in tech stocks has not only helped boost the large-cap indexes but has sent also the NASDAQ 100, which tracks the 100 largest NASDAQ stocks, to a new high. "We'll probably start seeing a revival of volume in the markets and a return of interest in the better-quality small stocks, but it will be less in `hope' stocks and more in stocks that have predictable earnings growth," says Farrell.

The market's next challenge is the upcoming third-quarter earnings season. Goldman expects earnings to be lackluster, but he notes that "after having so much cold water thrown on us after the second quarter, we're ready for disappointments, so the market isn't as vulnerable." Even the bearish Wien says he doesn't expect widespread earnings disappointments.

Greenspan may well decide to appease the hawks and nudge up rates at the Fed's Sept. 24 meeting. But with interest rates declining throughout much of the developed world and with inflation dormant, a tap on the brakes by Greenspan isn't going to tame this bull.

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