Dancing to the Street's Limbo Beat

Investors can bend over backwards looking for a bullish sign, and yes, they'll find a few. But the pros feel the bar still has a ways to drop

By Amey Stone

For a few days in late July it seemed that the market had finally crash-landed. As investor confidence caved amid a cascade of accounting scandals, the Dow Jones industrial average had plunged a brutal 27% to 7,533 from mid-May through July 24.

When stocks then rallied 18% in just four days from July 24 to 29 (a startling 1,317 points on the Dow -- the largest point gain ever in four trading days), many investment strategists went out on a limb and -- once again -- predicted that the bottom was in. Prudential Financial's Edward Yardeni, still a believer, wrote on Aug. 5 that the July 24 low was "probably the long-sought and oft-anticipated low for the year."


  Perhaps. But to many investors, it's looking increasingly likely that the market optimists spoke too soon -- again. In early August, stocks are plummeting once more and the sizeable late-July bounce is starting to look like yet another doomed bear market rally.

"There is nothing uncharacteristic with a bear market in what has happened," says Robert Burgoyne, an independent money manager in Ellicott City, Md., who is sticking to the sidelines. Rather than triple-digit dives and spikes, he thinks a market bottom will be signaled by stocks bumping along on low volume for months. "There are times when there is nothing better than having cash," he says.

Technical analyst Paul Shread of Internet.com is holding out for a string of days in which 90% of the volume is down on the New York Stock Exchange before he calls a bottom. Aug. 5, when down volume on the NYSE was at 88%, came close to that mark.


  For him, it would take just such a sustained level of selling, which we haven't seen yet, to signal the real "capitulation" -- the point when everyone who could sell has done so. Before the bears retreat, he thinks the Dow could go to 7,000 from around 8,050, while the the Standard & Poor's 500 drops into the 700 range from its Aug. 5 close of 834.

Fundamentally, there are plenty of reasons to explain why the rally may be flaming out. Even as the market was spiking in late July, weak economic news was pouring in. First came reports of slipping consumer confidence, then durable goods orders fell and an index of manufacturing activity disappointed, indicating that capital spending could be stalling.

A preliminary reading of gross domestic product (GDP) growth for the second quarter came in on Aug. 1 at a bleak 1.1%, as earlier quarters' growth was revised down. A weak employment report on Aug. 2 put a final exclamation point on the week of discouraging news. Good grief!


  Of course, "one month of data does not make a trend," says Chuck Hill, research director at earnings tracker First Call. "But when you have that kind of breadth of different economic indicators all disappointing, the caution flag was quite large." By the close on Aug. 5, the Dow was only 512 points away from its intraday low on July 24 of 7,532 and the S&P 500 was just 60 points from its low 775.

Hill says it is now pretty much inevitable that analysts will have to lower earnings forecasts for the third quarter and fourth quarter of 2002. Analysts predict third-quarter earnings will be up 12% (already sharply lower than their July 1 consensus of 16%), but Hill thinks the actual growth will be more like 5% to 8%. "It's hard for the market to go up when analysts are slashing their numbers," he says.

Many investors worry that the Aug. 14 deadline by which top executives at all large publicly-traded companies must certify their books as accurate will trigger more disclosures of corporate malfeasance. International tensions are building again and investors are increasingly worrying over the impact of an impending war with Iraq, not to mention the potential impact of the ongoing violence in Israel. "It's hard to make a case for owning stocks aggressively with a war looming," says Burgoyne.


  Even though investors are pessimistic now, the fact remains that they could become even more pessimistic. "The pendulum usually swings much too far to the negative at the bottom," says Hill. "Given the bubble and how far the pendulum swung to the over-optimistic side, logic would say we probably haven't seen the full swing of the pendulum to the negative yet."

Bernie Schaeffer, chairman of Schaeffer's Investment Research, says a combination of bearish technical indicators, weakening fundamental measures, and hopeful investor sentiment indicate that the bear market is far from over. "The possibility of major additional damage before the ultimate bottom is far from remote," he wrote to clients in August.

Despite the gloom, there are reasons for long-term investors not to give up. Earnings in the second quarter will by slightly positive, probably just 0.7%, says Hill. That would still amount to the first year-over-year growth for earnings in five quarters. Third-quarter growth at 5% would be quite a bit better -- and the fourth quarter should exceed that.

Consumer sentiment has been weak, but there is no evidence in economic reports that the consumer is throwing in the towel. And Federal Reserve Chairman Alan Greenspan is still optimistic that the recovery is on track.


  "It will take an intensification of the war fears and a deterioration of corporate governance issues to keep the market's downward trajectory in the face of still positive fundamentals," Milton Ezrati, senior economist and market strategist at Lord, Abbett, wrote to clients recently. "Though entirely possible, history and the likelihoods suggest that, ultimately, the favorable fundamentals will carry the day."

No doubt we're in the midst of a bottoming process that will eventually result in the market stabilizing and stocks resuming their ascent. Trip Jones, senior vice-president at Fulcrum Global Partners, summed up the recent selling in an Aug. 2 note: "I suspect investors are realizing that the bottoming process is just that -- a process and not a single event."

We may not breach the July 24 low, but investors who want to avoid additional damage to their portfolios may still want to steer clear for now. The problem is, as cheap as stocks are, investors have by now learned a painful lesson: They can always get cheaper.

Stone is associate editor for BusinessWeek Online in New York

Edited by Beth Belton

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