The Bulls May Get Trampled

Optimism in stocks is growing, but the numbers remain sobering

There's a joke on Wall Street these days that the stock market is sure to go up--just don't ask when. It has become especially pertinent since the market staged a strong, four-day turnaround starting on Oct. 10, with the Dow Jones industrial average and the Standard & Poor's 500-stock index both soaring over 13% before falling back 3% on Oct. 16. Investors want to know if the worst stock market slide since the Depression is finally over or whether they're just seeing another cruel bear-market rally.

Despite the profit-taking on the 16th, market soothsayers of all stripes are starting to convince themselves that it's onward and upward from here. For instance, on Oct. 10, Morgan Stanley chief technical analyst Rick Bensignor, called a bottom, saying: "I think we will stop the downtrend here."

Don't hold your breath, though. Sure, there are plenty of indicators, such as high volatility and what looks like a double-bottom formation on stock charts, that technicians say often signal a trough. Trouble is, this is at least the third bottom flagged by technicals this year. Says Salomon Smith Barney U.S. equity strategist Tobias M. Levkovich: "The worst could be over, but we're not out of the woods. We never migrate from a bear to a bull market overnight."

Fundamental factors still weigh heavily on the market--and some have reared their ugly heads only in the past couple of months. Profit expectations continue to be revised downward; the trustworthiness of accounting remains a worry; the threat of war with Iraq, as well as separate acts of terrorism such as the recent one in Bali, is dampening sentiment. And there's an increasing risk that consumer spending could erode if a significant rise in unemployment or an oil price shock produces a weaker economy than many anticipate.

Even though investor sentiment seems to be downright dismal, it may still not be dismal enough. "The speculative fervor hasn't been removed," says Richard Bernstein, chief U.S. strategist at Merrill Lynch & Co. "Investors are chomping at the bit, waiting for the next bull market to start." At a real market bottom, says Bernstein, "investors believe there will never even be a bottom." In fact, many strategists say it's likely that the market is in the midst of a "bottoming-out process" which could last well into next year. That means the market could give back the gains of recent days and move mostly sideways for a while.

What will turn the tide? Basically, healthy profit numbers that prove to investors, once and for all, that U.S. businesses are in the throes of a genuine recovery. But such a prospect is proving as ethereal as a mirage in the desert. Companies are putting off capital spending because of the uncertain economic and geopolitical environment. The likes of Citigroup (C ), General Motors (GM ), and Johnson & Johnson (JNJ ) are reporting improved net profits. But that's largely because last year's profits were so weak that companies are trumping them with relative ease.

Analysts aren't giving them any credit for the improvement. Indeed, they are continuing to slash their earnings expectations for S&P 500 companies. On July 1, they were projecting 17% earnings growth for the S&P in the third quarter, but that number has now dwindled to around 5%, according to Thomson Financial/First Call. Ditto for the fourth quarter, for which the July 1 consensus of a 28% gain has shrunk to just 19% now. Profit worries, say experts, have already started to extend to the first two quarters of next year. Says Brian Belski, market strategist at U.S. Bancorp Piper Jaffray: "We're seeing some positive [earnings] growth, but not the kind that defines a bull market."

Some say the profit concerns could mean the economy has simply entered a new leg of the bottoming process. Thomas McManus, equity strategist at Banc of America Securities (BAC ), calls this the "anticipatory phase," where the market's reaction to downward earnings revisions is so severe that investors finally believe expectations are being cut to reasonable levels. For example, on Oct. 9, General Electric Co. (GE ) shares sank almost 6% when analysts cut their 2003 profit forecast. The same day, an analyst's downward revision of AMR, parent of American Airlines, pushed the stock down 18% and punished other airline stocks including United Airlines. Such a process could last for weeks, warns McManus.

Sharp rallies of the sort that started on Oct. 10 often characterize a long bear market. From January, 1974, to August, 1982, the S&P staged six major rallies, each with an average gain of 32%, according to Salomon Smith Barney. In fact, in the first rally, which began in October, 1974, and lasted until July, 1975, the S&P posted a 53% gain before sinking 12% in the subsequent two months.

These days, rallies are turbocharged by the huge number of short-sellers. They are harvesting profits or being forced to buy back shares when stocks rise above the price at which they borrowed them. Since early 2000, short interest in the S&P has almost doubled to 2.25% of all shares outstanding. For a rally to be sustainable, serious new money must come into the market. Instead, since mid-May, investors have yanked $64 billion out of U.S. equity funds. And there's no sign they are about to change tack. Combine that with investors who are selling shares into any strength, and it's a recipe for another fizzled rally.

Also, investors could continue to choose bonds over stocks, especially if their yields start to rise. As investors have sought out safe havens away from stocks, Treasury bond prices have risen over 10% since the beginning of the year, making them one of the hottest investments around. But the yields have been at historic lows. If stocks start to rise, bond yields will likely rise. In fact, in the course of the recent stock market rally, the yield on a 10-year Treasury jumped nearly half of a percentage point.

To make matters worse, there's still a lingering question about valuations. Although stocks aren't hugely overpriced these days, they're still not cheap. The S&P is trading at about 18 times projected 2003 earnings. To some, that's fine, given the current low inflation rates and taxes. But historically, the market has traded around 15--and in typical bear markets, the ratio has often dropped under 10, and sometimes as low as 8. Of course, those low valuations generally occurred in high-interest-rate environments; given today's low rates, such a steep fall looks less likely.

That's one reason strategists such as Goldman, Sachs & Co.'s Abby Joseph Cohen haven't been deterred from calling the market "notably undervalued." On Oct. 9, Cohen forecast that both the Dow and S&P will rise roughly 48% over the next 12 to 18 months despite "intense risk aversion" among investors. "The worst is past," she said.

Maybe Cohen will turn out to be right. But some critics say she is simply egging on the chorus of investors who are still overly bullish. Says Belski: "Investors need to stop looking for the next bull market and recovery. They need to focus on what they're doing in this market first." That, he says, could mean finally dumping losers, especially tech stocks that are dogging portfolios; practicing sound asset allocation; and seeking out solid companies selling at reasonable valuations. They also need to realize that when the market does finally turn around, those bubble returns of 20% or more a year won't come back. A much more likely scenario will be 5% or 6% annual gains.

At least the market will be going up then--and perhaps the jokes on Wall Street will be a touch more upbeat.

By Marcia Vickers in New York

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