"We May Have Come Too Far, Too Fast"

Yes, the signs are positive, but stocks still look expensive and earnings may disappoint

On the surface, there's a rosy backdrop for a bull market: Rock-bottom interest rates. No inflation to speak of. And an economy that's showing signs of a surprisingly vigorous rebound.

So it's little wonder that improving economic news has already fueled a broad-based stock rally. True, the market averages rebounded sharply from September lows in the fourth quarter, but 2002 was starting out as a bust until Mar. 1. In just four trading days, the Dow Jones industrial average gained 4.6%. The tech-heavy Nasdaq is up 9.2%, while the Standard & Poor's 500-stock index boasts a 5.1% increase. Since September, those averages are all up over 20%.

Global stock markets are taking their cues from Wall Street, too. In the first few days of March, many bourses made striking gains. In Europe, London gained 2.8%, and Frankfurt 4.9%. In Asia, Hong Kong jumped 5%, and even Japan jumped 7.3%. Investors around the world are betting that the improving U.S. economy will lead the global economy out of its slump.

The sudden surge in stock prices sent Wall Street's market strategists scrambling to raise their forecasts. A few are now calling for a further 8% to 10% gain in the Dow through the rest of the year--and as much as 20% for the S&P 500. And even if the gains are only in the high single digits, that may be enough to bring nervous investors back. After all, money-market funds pay just 1.5%, which means the yield after inflation is actually negative.

Are we seeing the beginning of another bull market? No doubt the economy is on the upswing, and that usually foreshadows better corporate profits. But big obstacles will slow the stampede: Valuations are already high, and interest rates are already low. That's what you typically see in the later stages of a bull market, not the start. "We may have come too far too fast," says Sam Stovall, senior investment strategist at Standard & Poor's. "We may have a protracted period of treading water."

Indeed, a lot of good economic news is already built into stock prices. One common way to value the market is to compare the S&P 500's forward price-to-earnings ratio to the interest rate on the 10-year U.S. Treasury bond. Based on 2002 earnings forecasts from Thomson Financial/First Call, the S&P's forward p-e is 23. With a 5% yield on a 10-year bond, the fair value of the S&P's p-e is 20. That means the market is roughly 15% overvalued. Other valuation models show it to be 9% to 29% too high.

Nor can investors count on a helping hand from the Federal Reserve. In 1982 and again in 1991, the central bank helped stocks get moving by cutting interest rates. Falling rates boost stock prices two ways. First, lowering yields on interest-bearing instruments makes stocks incrementally more attractive. And even more important, lower rates make companies' future earnings more valuable. That's why investors will pay high p-e's for stocks in low interest rate environments.

But that's not going to happen now. After 11 consecutive cuts in 2001, most think the Fed is more likely to raise rates than lower them this year. "There's not a lot more room for rates to turbocharge the market," says Steven Galbraith, equity strategist at Morgan Stanley Dean Witter & Co.

Without a compelling interest-rate or valuation story, the case for stocks comes down to the higher earnings. But there's still a question of just how strong profits will be. Thomson Financial/First Call says the consensus among Wall Street analysts is that earnings per share for the S&P 500 will average $49.88 in 2002--a 17% gain over 2001's operating earnings. Should the forecast prove too low, and earnings come in at 20% higher, say at $60, the p-e would be 19. That would make stocks slightly more attractive than a 5% bond. But if the economy is strong enough to propel earnings that high, the bond rate will likely be higher, too. Then there is the quality-of-earnings pall that Enron has cast. No one really knows how accurate the corporate earnings statements are.

Even if the surprisingly strong economy is making people more sanguine about earnings, some serious concerns remain. First Call's Charles L. Hill worries that forecasts for S&P tech companies are too upbeat--a 137% gain in the third quarter, and 74% in the fourth. After all, Wall Street has a history of overestimating tech earnings. The other concern is with the financials, where earnings forecasts are up 48% and 44% respectively in the third and fourth quarters. Morgan Stanley's Galbraith thinks weakness in investment banking will crimp Wall Street, while problem loans will dog money center banks and credit-card companies. Technology and finance together account for more than a third of the S&P 500, so any problems in those sectors will hurt the market.

Of course, there are some market sectors where the earnings outlook is more upbeat. Economically sensitive stocks, both consumer and industrial, will improve along with the gross domestic product. Among those mentioned are retailers Best Buy (BBY ) and Sears Roebuck (S ), and manufacturer Stanley Works (SWK ).

Another positive for the market: mutual funds. Market researcher Leuthold Group estimates that $30 billion has gone into U.S. equity funds this year, about 30% ahead of last year's pace. That means lots of new buying power to supplement the cash already in the funds, estimated at $200 billion.

All told, the trend for stock prices looks like it's pointing up. But don't expect a replay of the 1990s bull market.

By Geoffrey Smith in Boston

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