The Bull Is Back
The bull is back. Just weeks ago, when despair was great and fear reigned supreme, the beaten-up stock market took off like a rocket, confounding the pundits--who are still scratching their heads. The Dow Jones industrial average has advanced more than 1,000 points in a month, and the awesome gains in small-cap and mid-cap stocks have left many investors breathless. "Is this market for real?" asked Anthony Pearce-Batten, the moderator who kicked off the Legg Mason Value conference for institutional investors on Nov. 10. "Or is this one of the biggest sucker rallies of all time?"
It's for real, all right. Although some economists fear that global financial turmoil could touch off a U.S. recession in 1999, several recent events and economic statistics paint a rosier picture: Third-quarter growth in the gross domestic product was higher than expected, world leaders are proposing solutions to the global economic turmoil, inflation remains at bay in the U.S., and the midterm congressional elections suggest that moderation may be in vogue in Washington--and a disruptive impeachment crusade may be passe.
STAYING POWER. True, corporate earnings were down 4% in the third quarter, but that was less than some investors feared--and many expect a pickup in 1999. "We've come pretty far pretty quickly," says James R. Margard, co-manager of Rainier Core Equity Fund. "But the market seems to be broadening out to the secondary stocks, which is important, and there still seems to be a lot of demand."
That breadth is what distinguishes this autumn rally from the one last spring and early summer. And that's what may give this rally more staying power. Back then, the market rose higher and higher on the backs of fewer and fewer big multinationals--the "New Nifty 50." At the market's peak in July, the Standard & Poor's 1500 Supercomposite, a broad mix of large-, mid-, and small-cap stocks, was up 20.7%, while the New Nifty 50, as measured by the Morgan Stanley Multinational Company Index, gained 24.1%.
Now, the tables are turning. Brian F. Rausher, a U.S. investment strategist at Morgan Stanley Dean Witter, says that from the market low on Oct. 8 to Nov. 9, the New Nifty 50 index gained 16.4%, but the S&P 1500 climbed 18.8%. If you measure the performance of each stock equally instead of by market capitalization, the average Supercomposite stock trounces the average Nifty 50 by 27.7% to 15%. That's not all: Of the 1,500 stocks, 876 have outperformed the index, and the smallest 10% of the 1,500 stocks--those with market caps of $114 million or less--are up a dazzling 38.6%. "This is a big change from what we saw earlier in the year," says Rausher.
One thing is unchanged, however: the market's obsession with Internet stocks. On Nov. 11, Yahoo! Inc. closed at 165, up more than 60 points in a month. eBay Inc., a Net-based auction service, zoomed up by more than 100 in the same period, including a 27-point jump on Nov. 10 alone.
CALM YEAREND. With such enormous gains in a brief period, the stock market could take a breather. But the calendar should work in its favor. Most equity mutual funds have closed the books on profits and losses for the fiscal year, and they're more likely to be buyers than sellers now. And with higher prices, many stocks that individuals might have earmarked for yearend tax-loss selling may stay put. The same goes for the hedge funds. In early October, hedge-fund watchers feared that a wave of redemptions in December would put downward pressure on the market. But with the recent upturn, many investors who had planned to cash out may well leave their money on the table.
Democratic victories in the Nov. 3 elections should also benefit stocks. The Republicans' losses in the House and their failure to gain in the Senate means "there's much less likelihood of a destabilizing political crisis," says Greg Valliere, managing director of the Schwab Washington Research Group. "The stock market would not appreciate impeachment in the House and a trial on the floor of the Senate." The new house leadership may also help. Speaker-apparent Robert Livingston "will be more disciplined on the budget, getting spending bills done early instead of rushing to complete them in October," says Charles A. Gabriel Jr., Washington analyst at Prudential Securities Inc. "Investors will see budget reform as positive."
BUOYANT. But a fundamental issue for equity investors is that many investment gurus say the likelihood of recession--much feared a month ago--seems to fade a little more with every economic statistic. The surprisingly strong third-quarter rise in GDP--up 3.3%--buoyed investors, even though economic growth slowed as the quarter progressed. And on Nov. 10, the Labor Dept. came up with another upside surprise: U.S. worker productivity accelerated in the third quarter, posting a 2.3% gain. Higher productivity is critical in keeping inflation in check.
Equity investors could get tripped up in the short run. For starters, a chunk of the market's October-November gains could be wiped out if the Federal Reserve fails to follow up its September and October rate cuts when the board meets on Nov. 17. Some think the recent strength in the economy might prompt the Fed to do just that. "It would be a catastrophe," says William H. Miller III, president of Legg Mason Fund Adviser Inc. Such a move would not only rile the U.S. equity market but might also upset the fragile emerging markets, some of which are finally starting to climb out of their financial morass. Brian S. Posner, who runs Warburg Pincus Growth & Income Fund, doubts the Fed will disappoint investors. Says Posner: "The Fed's rate cuts were a response to illiquidity in the markets, not to stave off recession."
Still, how much farther can this rally run? Big-caps, in particular, may be constrained by valuation problems. Edward E. Yardeni, chief economist at Deutsche Bank Securities, says stocks have gone from 16% undervalued in relation to bonds on Oct. 9 (the S&P at 984.4, and the 10-year Treasury-bond yield at 4.78%) to 4.7% overvalued on Nov. 6 (the S&P at 1141, bond yield at 4.94%).
A better earnings outlook could fix that. Although profits were down in the third quarter, they weren't so bad considering the global financial shock, the impact of the General Motors Corp. strike, and deflationary pressures on pricing. And market leaders such as IBM and Intel have reported results that exceeded investor expectations.
Stock investors typically look 6 to 12 months ahead, and by that point, profits may well have improved. If productivity increases at the current rate, companies will be able to absorb higher labor costs better. Some Asian economies are bottoming, too, and may even help exports revive. Finally, this year's weaker profits will make year-over-year comparisons in 1999 look good. Indeed, some think fourth quarter earnings will even show a gain over 1997's weak final quarter.
No question about it: Equities are no longer the screaming buy they were just a month ago. "Now, it's a stock picker's market," says Margard. Among the stocks he says are well off their lows but still attractive are tiremaker B.F. Goodrich; Suiza Foods, which sells dairy products; and U.S. Filter, a maker of water-treatment systems. Miller and Posner are fans of WPP Group PLC, the British ad agency that owns Ogilvy & Mather and J. Walter Thompson Co.
There's still the nagging problem of long-term rates, which have climbed along with stock prices. High long-term rates can limit companies' ability to finance new capital investment. But Arnold C. Schneider III of Schneider Capital Management says he can live with it. With most central bankers cutting short-term rates, it's natural for bond rates to rise. The cuts, say Schneider, amount to "a pro-growth policy, and it's good for stocks." The danger would come if rates spiked upward from these levels--but he doesn't think that's about to happen. "Not with inflation this low." For now, let the fun continue.