Crunch Time for Wall Street

If the economy doesn't start catching up soon to investors' rising expectations, this rally could be yet another false start

By Amy Tsao

Are the markets forecasting the economy six months from now, as they are reputed to do, or has irrational hope simply reached a four-year high? That's the question investors, market watchers, and more than a few candidates for political office in 2004 are contemplating as they try to divine whether the market's recent upturn heralds the long-awaited economic recovery.

Certainly, investors are expressing confidence that the economy is about to gain some traction. Even with two down days on July 9 and 10, the Dow Jones industrials average is up 8.33% in 2003, closing at 9036 on July 10. The S&P 500-stock index is up 12.37%, to 989. And the NASDAQ Composite has risen a surprisingly strong 28.47%, to 1716.

That's what should happen after the recent $350 billion federal tax cut, 13 Fed interest rate cuts, and the reasonably successful completion of a U.S.-led invasion of Iraq. It's also the predictable result of what, for all practical purposes, has been the disappearance of returns on safe investments such as bonds, CDs, and money-market funds -- a situation that has forced many investors to launch a search for something better.

And yet, in many quarters a nagging concern lingers that the market is fooling itself and everyone else -- or at least, that it can't run much further until the economy catches up. "Now that the war is over, we're still in the same boat," worries Charles Gabriel, political analyst at Prudential Securities. "You've got a weak global economy and a jobless recovery. That's the here and now."


  Even the sanguine view is less than inspiring: For the rest of the summer, "we should be range-bound, probably between 8500 and 9500 for the Dow," predicts Chris Jarvis, associate director of private-client research at financial advisory company Advest in Hartford, Conn. "Bond yields will test their lows again. There will be a push and pull for equities for some time."

The summer months are traditionally lackluster for stocks, of course, amid light trading volume and sparse corporate news. But this year's lull, assuming it materializes, will be more like a pregnant pause. That's because -- for the fourth year in a row -- economists and strategists have predicted a second-half economic recovery, and everyone hopes they'll be right this time. They're betting on a $70 billion, third quarter injection from tax cuts, plus lighter taxation of dividends and capital gains.

The latter, in particular, should encourage more stock investing, figures Donald Luskin, chief investment officer of Trend Macrolytics, a market research firm in Menlo Park, Calif. Luskin concedes that stocks aren't cheap. But with the S&P 500 trading at a multiple of 18 times 2003 earnings, compared with a multiple of 23 a year ago, stocks are "at least, way reasonable," he says. Thus he's optimistic that though "we may seesaw around, we will break out of trading ranges." He expects that the S&P 500 could rise 5% more, to 1050, before summer's end.


  Whether he gets his wish will depend primarily on the news from second-quarter earnings reports, which are just now coming out. Clearly, it wasn't a spectacular quarter. But earnings forecasts during the preannouncement season of the past few weeks were more stable than in the recent past, says Chuck Hill, director of research at earnings tracker First Call. He expects earnings growth of 8% to 10% for the quarter for the 4,100 companies First Call monitors in the U.S.

Profit prospects on the other side of summer are what investors will be keying on next. Guidance on the second half that companies provide with their second-quarter announcements will be watched closely -- and the market will be very sensitive to subtle shifts in tone, Luskin predicts. Second-half revenue growth "will not be substantial, but there should be an improvement" if the market is to hold its gains, says Brett Mitstifer, senior portfolio manager at Value Line Asset Management.

That's because the next step would likely be an uptick in capital spending -- the key to growth in both jobs and gross domestic product. Outlays for new plant and equipment have fallen 16% since 2000, and any significant improvement in that trend would start to get investors excited. So far, however, it's mainly straws in the wind on this front. On July 7, for instance, Taiwan Semiconductor reported a sales increase of 14% for June, a sign that technology demand may be recovering.


  On the same day, Goldman Sachs released a survey showing that companies plan to increase their budgets for purchases of hardware and software somewhat in 2004. The increased willingness to spend "was a very modest uptick, but it was in the right direction," Hill says.

Another clue to the second half will be the employment picture. Most market watchers brush off the June increase in joblessness to 6.4% from May's 6.1%. Still, trends in productivity and employment continue to paint a picture of corporate penny-pinching. A slackening in productivity gains and an increase in employment would show that companies have begun to expand again, which at this point investors would view as a favorable sign.

Indeed, Wall Street's newfound optimism is accompanied by an anxiety that will last until companies show signs of emerging from survival mode. "Until then, this rally will be short-lived," Jarvis contends. Consider the market's reaction on July 10 to the surprising rise in weekly jobless claims: Unnerved investors drove the Dow down 150 points at one point, and it closed with a 120-point loss.


  First Call's Hill agrees -- and he complains that "the crystal ball is fuzzier than it has ever been." During the second-quarter preannouncement season, companies in sectors he considers key to a recovery -- materials and consumer cyclicals -- have issued more warnings than usual. In coming weeks, Hill will be looking to the earnings announcements of auto makers, retailers, makers of home appliances and furnishings, and entertainment and restaurant companies to "tell the tale" for the rest of the year.

So while the bulls have more reason than in recent years to enjoy a testosterone high, a lot of things will have to go right for stocks to maintain their current trajectory. All investors can do for the next few weeks is to watch carefully for signs of whether the rally is for real -- or a summer mirage.

Tsao covers financial markets for BusinessWeek Online in New York

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