How Far Can This Bull Run?

The market's two-month rally has buoyed investor confidence. Still, several factors could easily pull the bears from hibernation

The stock market has been on quite a rocket ride the past two months. Since the sharp sell-off following the terrorist attacks of September 11, the Dow has climbed 23%, closing above the 10,000 level for the first time since Sept. 5, while the Nasdaq composite is higher by some 45%. If a stock market rally is supposed to predict an economic recovery six months later, that's good news for both Wall Street and Main Street.

Can it continue? Well, the long drop may be over, but before the bull can really get running, investors can expect the next two months to prove a volatile time for stocks. Even as hopes brighten for the economy in 2002, the markets will need more solid evidence of a recovery to keep the rally going. Trouble is, in the near term, any number of curve balls could spook investors.


  For one, valuations remain extremely high. Standard & Poor's says its benchmark S&P 500-stock index is still trading at a price-to-earnings ratio of 28 (2001 estimate), far above the historic average of 15. "At the rates we're at right now, this pumping-up phase probably lasts for a little while. But when investors realize earnings don't support valuations out there, we'll probably end up declining again," says Mike Farrell, portfolio manager and strategist at Cambridge (Mass.)-based investment adviser David L. Babson & Co.

Although the market has been in bull territory since the third week of November, a few bearish growls can still be heard. Ebullient investors are already looking past fourth-quarter earnings reports, which are expected to be dismal. But some analysts warn that first- and second-quarter 2002 profits won't be nearly as upbeat as rosy-eyed investors are anticipating. "I suspect that the fourth quarter will be vastly weaker than people expect," says Farrell. "The real story is when you look at 2002 earnings estimates. Right now, they are dramatically too high."

The exuberance has been fed in part by announcements by tech bellwethers such as Cisco that declines in their business seem to be stabilizing. That doesn't mean corporate purchasing managers are ready to reopen their wallets, however. "We continue to see firms under pricing pressure. Across the whole economy it's quite weak," says David Watt, financial economist at Nesbitt Burns, Bank of Montreal's equity subsidiary. Watt and others are worried that many companies will revise downward their 2002 forecasts during the fourth quarter pre-earnings warning season, which begins in the last two weeks of December.


  The impact of a worsening job market could also dampen investor sentiment. Job losses were revised upward from 415,000 to 468,000 in October, according to the latest Labor Dept. report, and 331,000 jobs were cut in November, which is much worse than economists had expected. "We see more job losses going forward," Watts says. Another factor is the effects of layoffs on the critical Christmas shopping season, which retail analysts say has already been hurt by unseasonably warm weather.

As 2001 comes to a close, investors should also be wary of the consequences of profit-taking by portfolio and fund managers. Many professional money managers are expected to sell in December to make up for sharp losses over the rest of the year, and that could drives stock prices down. Ed White, chief equity strategist at Boston-based Gannett Welsh & Kotler, says the recent rally certainly has made profit-taking a priority for him. In recent weeks, he has sold some technology stocks and bought financial stocks with lower p-e ratios.

The idea is to sell stocks at yearend and buy them back at cheaper prices at the start of the new year. "With less than one month left of trading, who wants to bet their bonus that the rally will hold," says Trip Jones, senior vice-president at New York-based brokerage Fulcrum Global Partners.


  So, how should investors play the jerky market? "I am waiting for dips to buy," says Larry Wachtel, senior vice-president for national sales at Prudential Securities. "I don't want to go chasing things, having learned a lesson from the 18-month bear. My only tactical change is to wait for a pause to get my ducks in the pond."

Scary? A little bit. But investors with eyes trained on a long-term horizon shouldn't get flutters in their stomachs. More and more of the evidence suggests that a recovery will be in the works by around the second half of 2002. Better-than-expected economic updates, especially in the hard-hit manufacturing sector, and more optimistic comments from the high-tech sector are reasons to cheer.

Successes in the war in Afghanistan have lifted a big burden from investors' shoulders. Meanwhile, the government's efforts -- through lower interest rates for borrowers and the prospect of a stimulus package -- also spell good news for the economy.

Add low energy prices to the mix, and the economy seems to have all the ingredients it needs to get out of recession in 2002. "All those factors suggest a rebound is being aggressively coordinated," says Eric Leo, chief investment officer at Allied Investment Advisors, based in Baltimore. While the short term may see its share of bumps, the 18-month bear market may indeed be at an end.

By Amy Tsao in New York

Edited by Douglas Harbrecht

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