Afraid Of Market Heights? Don't Climb Down Now

The signs are still heady: Low inflation worldwide, strong profits, and rising productivity

Mountain climbers often describe the intoxicating rush they experience from scaling ever-higher peaks. They're also mindful that the lack of oxygen at high altitudes can make them ill and cloud their judgment so much they may not know when it's time to turn back. The Dow Jones industrial average, at 7289, has risen more than 800 points so far this year and has nearly doubled since late 1994. Still, millions of investors are pouring billions into stocks. Are they suffering from altitude sickness?

Not at all. The stock market may seem like it's at Himalayan heights, but this is no time for investors to get off the mountain. True, the market can be scary up here. The Dow lost nearly 700 points from Mar. 11 to Apr. 11. But what has been propelling stocks for the last several years is still at work: rising profits, low inflation, and much-improved productivity.

COOL SENTIMENT. The case for stocks may be even more compelling now. Economic growth surged to the highest level in more than a decade, unemployment to the lowest level in more than two decades--and even so, inflation remained quiescent. The likelihood of a reduction in the capital-gains tax and a political shift toward a balanced budget make it a nourishing environment for equity investments.

Low inflation is a worldwide phenomenon. "That's not just the result of monetary policy," notes Greg A. Smith, chief investment strategist for Prudential Securities Research. "The fall of the Berlin Wall, the spread of capitalism, and the rise of global competition have unleashed forces that are keeping inflation in check." So there's little danger that the U.S., with its huge appetite for foreign goods, will unwittingly begin to import inflation.

The global business environment plays right to the strengths of large U.S. multinational companies like General Electric, IBM, Intel, Merck, Microsoft, and Procter & Gamble, which, not surprisingly, have been among the leading stocks in the U.S. market. Many portfolio managers and strategists think they're likely to remain so, much to the frustration of those who invest in small- to mid-cap stocks. So far this year, the Standard & Poor's 500-stock index is up 14.3%, well ahead of 9.9% for the S&P MidCap 400 and 7.4% for the S&P SmallCap 600 (chart).

Despite the most positive environment for equities since the 1950s, some of the pros--especially those who control or influence large pools of equity capital--are surprisingly cool toward stocks. Sheer momentum can take the market up an additional 5%, says Byron R. Wien, U.S. investment strategist for Morgan Stanley, Dean Witter, and Discover, "but then it will get volatile, and ugly." Wien has been advising his clients to raise cash, arguing that the economy is strengthening so much that long-term interest rates will rocket toward 7.5% or 8% and blow a big hole in the stock market.

A stronger U.S. economy in the second half? Not likely. The economy is already showing signs of slowing from the first quarter's blistering 5.8% GDP growth. The second quarter could come in as low as 3%. There's a good chance the policymakers at the Federal Reserve Board are also expecting growth to moderate. After hiking short-term interest rates a quarter point in March to cool the economy and ward off inflation, the Fed board members declined to take any action at their May meeting.

Still, even with a backdrop of steady interest rates and surprisingly good earnings, many investors are concerned about valuation indicators. The market's price-earnings ratio is more than 21, and the dividend yield, just 1.75%. But recall that stocks looked richly valued one year and 1600 Dow points ago, and the market kept rising nonetheless.

RESILIENCE. "Those who have become obsessed with valuation measurements have missed the market," says Raymond A. Worseck, chief economist for A.G. Edwards & Sons. "There are plenty of people who are trying to talk down the market because some magical number in their model has been violated." Heck, even Fed Chairman Alan Greenspan couldn't talk the market down from its heights.

What many valuation models don't factor in is the extraordinary demand for stock from individuals, mutual funds, foreigners, and corporations. That's what mutual-fund manager Tom Gunderson of Advantus Capital Management in Minneapolis discovered. During 1995 and 1996, his usually reliable asset allocation model, which he used to apportion fund assets among stocks, bonds, and cash, left him with too few stocks and lagging returns. Back at the drawing board he realized, despite a booming market for new issues, that demand was overwhelming supply by 2%, putting upward pressure on prices.

The resilience of the bull market is remarkable--and is what makes market maven Laszlo Birinyi of Birinyi Associates Inc. upbeat. "When the market goes down, it's usually because investors became price-sensitive and stopped buying, not because of a huge amount of selling," he says. Such behavior, he adds, suggests investors are not acting recklessly.

Ironically, the evidence shows that bearish sentiment is a plus for the market, notes Richard Bernstein, director of quantitative research at Merrill Lynch & Co. The reason: Bad news is already discounted and investors have lots of cash. And right now, investment advisers are downbeat. One of Bernstein's indicators measures the equity allocations recommended by Wall Street strategists. Late last year, that indicator went below 50%, and whenever that happens, stocks gain some 20% in the next 12 months.

Perhaps the hardest decision facing investors now is whether to stay with the pricier large-cap growth stocks that have done so well or to turn to the recovering small- and mid-caps. Edward Keely, portfolio manager of Founders Growth Fund, has invested in secondary stocks such as LAM Research, Sunbeam, and Qualcomm, but still thinks the best opportunities are in the big companies like American Home Products, Lucent Technologies, and Northern Telecom.

Some investors may wish to hedge by taking some profits in big-caps and investing in smaller issues. But the most important thing: Stay on the mountain.

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