Skittish Bulls

They aren't turning tail yet. But they sure are edgy about rates

For months, market bears have been waiting for the sign that the end to this endless bull market was in sight. On Apr. 27, they thought they saw it: reports that the Federal Reserve was leaning toward raising interest rates.

The market was already wobbling the week before--the Dow Jones industrial average dropped more than 120 points from Apr. 21 to Apr. 24. But when the Dow tumbled as much as 223 points on Apr. 27, so too did some expectations that a 10,000 Dow was close at hand.

Talk of how all of the new money pouring into the market would propel it to new highs gave way to ominous mutterings about rising interest rates and slowing earnings growth. With Treasury bond yields rising in anticipation of a Fed move, investors saw that the profit predictions that had powered the price-earnings multiple on the Standard & Poor's 500-stock index to 23, based on estimated '98 earnings, were not merely optimistic, but perhaps a bit rash. "The current levels of stock prices, earnings, and bond yields just don't make sense," says Douglas R. Cliggott, J.P. Morgan & Co.'s chief U.S. equity strategist.

Clearly, that's part of the debate at the Fed. Some Fed officials point to the growing gap between the earnings companies can deliver and the earnings investors expect as a sign of speculative excess. Those inflated stock prices could spur even greater consumer spending and bring on inflation. By the same token, if profits disappoint, they fear a crash that slams the economy.

GREAT BUBBLE? So, where are stocks headed? This is still that same bull market--the one that wolfsbane, garlic, and maybe even a stake in the heart can't seem to discourage. Even with the Dow setting records, investors keep coming: According to the Investment Company Institute, more than $61 billion has poured into stock mutual funds by the end of March, compared to $56 billion in the first quarter of 1997.

The April correction already seems to be tapering off--the market closed up 52.5, at 8951.5, on Apr. 29. And many strategists, while not predicting large gains for the rest of the year, discount the idea of anything more than a temporary pullback. "It's that the market has gotten ahead of itself rather than `This is it--it's all over,"' says Cliggott. Goldman, Sachs & Co. strategist Abby Joseph Cohen thinks the current economic and profit expansion will last till the end of 1999, and an improving global economy will speed profit growth, though she expects U.S. economic activity to moderate. Cohen sees the Dow hitting a modest 9300 by yearend.

Still, the mood on the Street has changed. Many strategists are adopting a more cautious tone in the near term, while holding out hope for another upswing later this year. The second quarter, they say, will be choppy. Sizable price gains may be followed by stagnation--trading within a narrow range for perhaps months at a time.

Some pros, such as Morgan Stanley Dean Witter & Co. global strategist Barton M. Biggs, are fully bearish. He says this is "one of the greatest stock market bubbles of all time." Biggs's gloomy scenario: Wage inflation, already visible in services, will burst the bubble. Rising wages may force prices higher--igniting rapid inflation--or take down corporate profits as companies try to hold the line on prices while costs soar.

The biggest question overhanging the market remains: When, and by how much, will the Fed raise rates? "Our answer is not soon, and not much," says Cohen. But Barry Hyman, chief market analyst at New York City's Ehrenkrantz King Nussbaum Inc., believes the Fed is handing the markets a warning: "The media and the markets are being told, `Look, you better start thinking about higher rates because there's no room for flexibility here."'

That has market strategists focusing more intently on the fundamentals of the domestic economy--the forces that could prompt the threatened hike. "The first quarter is over, and the Asian impact hasn't hit, so now the Fed is looking at unemployment, at capacity utilization, and at jobless claims and seeing that the economy is even stronger than it was a year ago," says Joseph Battipaglia, Gruntal & Co.'s strategist. "And financial asset values are higher than a year ago." In classic Fed illogic, he says, "they worry about prosperity."

But despite the news that the Fed has shifted its bias toward tightening, a rate hike is not set in stone. Indeed, with no clear signs of rising inflation, the Fed is unlikely to raise rates at its next meeting on May 19. And plenty of strategists still think there won't be a hike before next year.

Indeed, in the wake of the Apr. 27 Fed leak, the market went about doing the Fed's work for it. After rising to 6.07% on Apr. 28, up from 5.95% on Apr. 24, the 30-year Treasury bond is hovering around 6%. "The bond market is acting like a vigilante," says Battipaglia. "Now they're saying there will be several increases coming." Cliggott calculates that if the long bond stays at 6.07%, earnings growth would have to be 9% to 10% for the market to be at fair value. He predicts earnings growth of 5% for 1998.

In recent years, long-term rates have been the key to the economy, says Peter J. Canelo, U.S. investment strategist at Morgan Stanley Dean Witter. "When variable mortgage rates went up in 1994, it really slowed things down in 1995," he notes. "Two more notches up in rates would get us to 6.25%, which would send mortgage rates up and slow the economy down." That may be all the economy needs, he adds.

The other key factor is earnings growth. While first-quarter profits are coming in better than expected, that's not saying much. There was an unusually high level of downward revisions to earnings estimates, making some of the on-target and above-expectations reports misleading. First Call Corp. normally expects to see estimates revised downward by 2% to 3%. But while expectations for year-over-year growth in S&P earnings was 10.4% on Jan. 2, analyst estimates now point to a tiny 0.5% gain. Normally, earnings come in with a slight positive bias, which would bring that growth figure to about 3%. "The bulls say we're beating the numbers," says Chuck Hill, First Call's research director. "That's baloney. Beating numbers by 2.7% is business as usual."

Still, the signs of overheating are there for those who seek them. Housing starts, existing-home sales, and mortgage applications and refinancings are still strong, notes Canelo. He thinks the interest-rate-generated boom of the last year will continue despite higher rates. That, however, could guarantee a rate hike in July if the economy doesn't slow: "The Fed knows it is constrained with domestic and international pressures, but they really feel that these booming markets have been part of the strength in the economy, because people feel richer."

Investors' faith in the bull seems unshakable, but it will be tested again and again as jobs reports and other economic data roil the the markets in coming weeks. Whether investors will continue to see such wobbles as buying opportunities isn't clear. What is clear: Investors can expect a long, volatile summer.

Before it's here, it's on the Bloomberg Terminal.