Nearing "a Tipping Point" -- to the Upside?

Sure seems unlikely these days. However, a team at Morgan Stanley argues that forces capable of ending the gloom are building

By Gene Marcial

With the major market averages close to breaking below significant floor levels -- which could send out a massive sell signal all round -- the uppermost question is: "How much more can this market fall?" Answers from Wall Street's pros vary -- mostly on the depressing downside.

Still, believe it or not, some strategists are starting to say that with the backdrop so bleak and dismal for so long, some light is becoming visible. You could hardly see that from what the indexes are doing: The Dow Jones industrial average closed on June 3 at 9701, the Standard & Poor's 500-stock index at 1039, and the Nasdaq composite at 1560 -- all way below their early March highs, reached after the depths of September.

On Tuesday, June 4, the averages are still mostly in retreat. Market technician Andrew Addison, editor of Institutional View newsletter in Franklin, Mass., warns that Dow's closing below 9800 ends a streak of "higher bottoms since the September low and triggers a sell signal." For the Dow to stabilize, he says, it must push quckly above 10,250.


  Certainly, the reasons are plentiful as to why the market is running scared: A worsening geopolitical situation, a pervasive lack of confidence in corporate earnings, and a proliferation of very negative corporate news: On top of the Enron and Andersen scandals came the sudden resignation of Tyco CEO Dennis Kozlowski amid charges that he evaded sales taxes in New York State.

Nevertheless, hope endures. In looking at both the market's technical behavior and the economic fundamentals, Morgan Stanley market and economic strategists Steve Galbraith, Mary Viviano, and Jay Lasus now conclude that "we are likely approaching a tipping point for sentiment (and perhaps stock prices)," says Galbraith. The market has been so down for so long, that "it's starting to look up," he says.

But before things could really swing positively, investors need to see "the whites of the eyes of corporate earnings growth," he adds. In an uncertain financial and geopolitical environment, "myopia clouds the outlook," Galbraith argues. Robust economic data ring hollow, he says, in the face of earnings declines.


  However, the Morgan Staley strategists are among those who believe that better earnings numbers will show up soon. "The second quarter will likely mark the first quarter of positive year-over-year earnings growth since the fourth quarter of 2000," says Galbraith. Investors can then begin to devote more time to anticipating what earnings will be -- rather than worying about what they have been, he says.

For those who argue that investors will have to endure pain equal to the joy they enjoyed in the 1990s, these strategists believe that, in fact, the largest annual profit decline in over 40 years and five consecutive down quarters will prove sufficient pain on the earnings front.

According to the Morgan Stanley team's calculations, earnings of companies in the S&P 500 will grow at a roughly 20% clip in the second half. About 50% of those companies posted profit declines in 2001, the analysts note. And Mideast tensions aside, "growth should do wonders to help restore investor confidence," says Galbraith.


  He also expects revenues to be on the rise by the second half. He notes that in the first quarter, corporate sales declined by approximately 5% vs. the same period the prior year. "Our guess is that by the third quarter, earnings will be increasing at a double-digit clip, while revenues will be back in the black," says Galbraith.

So where will this corporate growth come from? The Morgan Stanley team expects the financial and energy sectors to stand out as the "yin and yang of growth."

The financials, benefiting from easier prior-year comparisons, will provide a nice earnings lift for the market. The energy companies, "lapping very difficult comparisons," are expected to report earnings declines, according to most analysts. But Galbraith expects many of them to go against that wisdom. "Benefiting from high oil prices generated by the Middle East disruptions, the energy patch may in fact prove to be a source of positive [earnings] surprises," says Galbraith.


  For investors who truly fear the geopolitical outlook, Morgan Stanley's advice is to avoid defensive equities and go into government bonds. On the other hand, with earnings about to "escape a long period of dormancy, if the geopolitical center can hold (even relatively), investors should be maintaining a pro-cyclical tilt to their portfolios," advises Galbraith.

Some examples of where Galbraith says investors should look: shares of industrial companies, consumer outfits oriented toward discretionary spending, and basic materials. For investors spooked by a "a scary world," Morgan Stanley recommends shares in health-care and energy. If you believe that "to win you have to invest," these sectors could provide a relatively safe -- and possibly profitable -- refuge.

Marcial is BusinessWeek's Inside Wall Street columnist

    Before it's here, it's on the Bloomberg Terminal. LEARN MORE