The Bull Is Only On A Break

Shock over the euro's ills and rising energy prices won't last long

The stock market's march toward recovery has taken yet another detour. This time, the churning global economy has thrown up the roadblocks: Rising oil prices, weak foreign currencies, and bad news about earnings have reversed August's upward trajectory faster than investors could say "Labor Day weekend."

Just look at the numbers: Nasdaq's mini summer rally has been more than wiped out in September, while both the Standard & Poor's 500-stock index and the Dow Jones industrial average have fallen about 5%, erasing all of last month's gains and then some. All three indexes are now in the red for the year.

These very real shocks of rising oil and currency costs are thrashing companies' profits and unraveling exchanges worldwide. Is it enough to derail the bull market? "No," say strategists. They argue that the view on how these costs--oil at $37 a barrel, a 10-year high, and the euro at $0.85, an all-time low--affect the overall market is overblown. "A bellwether company announces [a shortfall] and all of a sudden the entire profit history for America is going to hell in a handbasket," says Brian Rauscher, market strategist for Morgan Stanley Dean Witter. "Once we get through that, we'll ease into a decent rally. Profit growth is still strong."

Goldman, Sachs & Co.'s market strategist, Abby Joseph Cohen, echoes that view. "Energy costs are a relatively small portion of total business costs, at less than 5%," Cohen says. "The U.S. economy has become less sensitive to changing energy prices as a consequence of the shift toward the service sectors." Cohen's 2000 target of 1575 for the S&P 500 has been unchanged since January.

IMMUNE TO SHOCK. Higher energy costs have slammed some sectors. Transportation stocks fell 11% relative to the S&P last month and have yet to recover. Consumer cyclicals slid 10%, though they have recovered 80% of that loss so far this month, Rauscher says. But technology, finance, and health care, which represent 47% of the S&P's profits, are relatively immune to energy shocks, he says.

However, there are risks to rising energy costs. Higher oil prices put upward pressure on wages and, ultimately, on core inflation. That "cost-push inflation, the kind that took [ex-Fed Chairman Paul] Volker two recessions to cure," is the market's worst fear, says Ronald Hill, chief equity strategist for Brown Brothers Harriman & Co. "It's not outside the realm of possibility, but if it's on the horizon, it's pretty far out."

The stock market's reaction to the euro's weakness might be inflated, too. Bruce Steinberg, chief economist at Merrill Lynch & Co., estimates that the currency translation by U.S. companies operating overseas will cut roughly 60 cents of $52 a share in earnings from S&P 500 stocks this year. And it will shave two percentage points from earnings growth in the third quarter, reducing it to a still heady 14%. Even if the euro doesn't rebound, Steinberg maintains the effect will be smaller in the fourth quarter and neutral by 2001. "Big swings in exchange rates have fairly minor effects on corporate earnings," he says, though some companies will get pinched. Technology companies--which count on 40% of sales from Europe--could "potentially have some serious currency issues," he says.

Multinationals that get more than 50% of their earnings from foreign business and which run unhedged portfolios are also at risk. Indeed, the stocks of Coca-Cola, Procter & Gamble, McDonald's, Colgate-Palmolive, and DuPont have been punished lately. Gillette stock fell 9%, to its lowest in four years, after it said slow overseas sales would hit quarterly earnings. The company, which generates more than half of its sales abroad, fell 2 cents short of analysts' expectations, to 34 cents a share.

BAD SEASON. The steady flow of announcements of corporate earnings shortfalls may sound like overall corporate earnings are headed south. But in fact, negative pre-announcements are running at about 66% for all three quarters of 2000--below a historical average of about 80%. Says Joseph Kalinowski, an equity strategist at I/B/E/S International Inc.: "We're in for another record-breaking third quarter for earnings." The consensus forecast for year-over-year profit growth is in the mid-teens for both the third and fourth quarters, says Kalinowski. That's down from nearly 20% rates early in the year, but still well above historical norms.

These are seasonally bad times for the stock market. The S&P has averaged a 0.3% decline every September since 1950, says Wall Street historian Yale Hirsch of The Stock Trader's Almanac. Worse, since 1964, there have been 11 market declines during the fall season of over 10%, he says. In seven of them, the most severe damage was done in October.

But as long as the market gets over its seasonal jitters, the economics are in place for an upward course: Productivity gains are still accelerating, inflation is tepid, and it's likely that interest rates will begin to drift downward as job growth slows and business inventories continue to build.

Managing expectations may be the market's biggest challenge, says Laszlo Birinyi Jr. of Birinyi Associates Inc., a money management and research firm: "We have a chance to make it a good year, but it's going to be single digits." Further evidence why investors should take heart: History shows that a bearish fall season often leads to a bullish fourth quarter.

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