Is That a Wind Shift on Wall Street?

First-quarter earnings shortfalls will keep coming, but some underlying economic trends may be signaling a second-half pickup

By Margaret Popper

On Apr. 3, when the Nasdaq slipped below the important psychological barrier of 1,700, some tried to blame the market's sell-off on the fear of war. According to that theory, investors believed the forced landing of a U.S. spy plane in Chinese territory had the potential to snowball into a full-fledged Sino-American War. The threat of war isn't what ails the stock market. It's the threat of no profits until the second half of this year.

"There are no signs that the affair in China was being taken that seriously by the market," observes Rodney Johnson, president of Dallas-based H.S. Dent Investment Management. "Defense stocks didn't rally, financial services stocks didn't drop suddenly, and there was no huge move to safety away from the stock market, as is common when there is a threat of war."

A more plausible explanation is that investors have at times been lost in the wind tunnel of first-quarter earnings reports, most of which have been disappointing. But the fact is that the broader economic picture isn't all that bad, especially since consumers -- who account for two-thirds of economic activity -- seem to be holding up just fine. Indeed, the powerful rally on Thursday, Apr. 5, reflects that the mood on Wall Street may be starting to shift to the view that quarterly earnings declines will stop with the end of the first half of 2001 (see BW Online, 4/5/01, "At Last, an Honest-to-Goodness Rally").


  Of course, we still have the first- and second-quarter profit woes to get through, and there'll be selling on Wall Street to manifest that pain. But recent economic data suggest we may be closing in on what had been an imbalance between supply and demand in the corporate sector (see BW Online, 3/14/01, "Don't Expect a Bottom Until...").

Numbers from the National Association of Purchasing Managers as well as the Philadelphia Fed show that companies are starting to spend again, if more slowly than before. "The liquidation of inventory has been faster than expected," observes Milton Ezrati, senior economist and strategist for Jersey City (N.J.)-based fund manager Lord, Abbett & Co. Thanks to that speed, Ezrati expects gross domestic product growth of about 2.5% at an annual rate in the third quarter and perhaps as much as 3% in the fourth -- pretty darn good for an economy that many had thought was teetering on recession. In the first quarter, he estimates there was no economic growth, not a good thing, but far better than an outright contraction.

The quick inventory correction may also have helped save jobs, and that has helped keep the consumer side of the economy relatively buoyant. "Employment is the dam holding back the erosion of consumer confidence," says Christine Callies, chief U.S. investment strategist for Merrill Lynch. "The deluge of layoffs happened late last year and early this year, but they were mostly restricted to autos, retail, telecoms, and Internet companies." Given that surveys show inventories have readjusted to more or less the right levels, Callies thinks the worst of the layoffs are already history.


  This newfound optimism isn't restricted to equity strategists, who make a living trying to convince their firms' clients to buy stocks. One positive sign that current stock prices warrant the future earnings risk is that balanced-fund managers are buying stocks again, Callies says. These value-oriented fund managers balance their portfolios among bonds, stocks, and money-market instruments depending on how the wind on Wall Street is blowing.

The Investment Company Institute tracks what these fund managers buy and sell. "For much of 2000, balanced funds were net sellers of equity, particularly in the first quarter," says Callies. "But in January and February of 2001, they bought at the heaviest rate they have in 2 1/2 years."

Since an ugly market day like Apr. 3 is generally an invitation to buy for these value addicts, their participation in the market doesn't generally produce spectacular turnarounds, but their presence is key. "It's the main difference between the beginning of a correction, when these guys are nowhere to be seen, and the end of a correction," when they come out in droves, Callie says. She also anticipates that profits will start to turn around in the third quarter of this year.


  Of course, the market still hasn't priced in the full extent of the earnings decline for the first quarter. And stock prices are likely to tumble with each new disappointment, as well as on rumors like the one that Lucent (LU ) is on the verge of bankruptcy. The company vehemently denied the allegation, but the speculation was a catalyst in the Apr. 3 slide. On a day like that one, when the Nasdaq lost more than 6% and the other major indexes were down more than 3%, investors want nothing more than a reassuring interest-rate cut -- before the May 15 meeting of Federal Reserve policymakers.

But don't get your hopes too high. Although he'll do what he can to bolster morale, Fed Chairman Alan Greenspan is already treading a fine line between supporting stock prices and setting the economy up for future inflation. With economic data looking O.K., it's hard to rationalize the rate cuts other than as a sop to the ailing stock market. "It is not the mandate of the Fed to insure the stock market of a bailout," says Eric Wiegand, director and equity strategist for Credit Suisse Asset Management and the Warburg Pincus private client group.

One key concern over the Fed's aggressive easing policy is that the money supply is suddenly growing at a very fast clip -- 14% for the broadest measure, M3, compared to no growth for the past couple of years. Once the market starts to recover, that could spell inflation trouble. "Late this year the market will have to drain liquidity from the system. Greenspan will have to undo this," says Lord, Abbett's Ezrati.


  In the meantime, investors will have to get through first-quarter earnings announcements as best they can. That spells volatility, even if there's value at current levels. "We think the Nasdaq could end up in the 1350 to 1550 range, but under 1650, there is still value," says H.S. Dent's Johnson.

Although it takes plenty of guts, investors might do well to imitate the strategy of the balanced-fund managers and buy on the down days. If you think the economy will rebound in the second half, there's no harm in buying on the up days either.

Popper covers the markets for BW Online in our daily Street Wise column

Edited by Beth Belton