'Tis the Season for a Correction

The Street is sensing that this rally is due for a dip

It's noon and the Charles Schwab (SCH ) branch at Rockefeller Center in Manhattan is bustling. At least five people are filling out account applications while 10 others, watching the electronic ticker, wait to meet with account reps. "A lot more folks have been coming in," says branch manager Keith Huber. "They want to participate in the rally."

No wonder. Despite a couple of recent down days, the market has been on a tear. The NASDAQ Composite Index reached an 18-month high on Sept. 8. The Dow Jones industrial average is now in its seventh straight winning month and the Standard & Poor's 500-stock index continues its ascent, posting a 15% gain so far this year and a 26% gain from its March low.

But this might be as good as it gets, at least for a while. Market signals point to a likely correction by the end of the month -- of as much as 15% -- before stocks resume their upward swing, perhaps toward the new year. "The recent rally has just been delaying a much-anticipated correction," says Richard McCabe, chief market analyst at Merrill Lynch & Co. He believes that the market is "overbought" -- that is, the 10-day moving average of advancing issues are outnumbering declining issues by a ratio of about 1.7 to 1 (1.5 to 1 is getting lofty, he says). Also, since 1998, rises in the S&P after March of 10% or more have lasted an average of 79 trading days. But this one has lasted 125 days, making it "too long in the tooth," says McCabe.

Of course, there are sound reasons why stocks are climbing. The economy is improving -- some economists are even predicting 5% growth in gross domestic product for the second half of this year. Productivity is high -- good for corporate profits. And the dollar has recovered much of its losses of the spring.

But investors often overplay good news. The NDR Crowd Sentiment Poll from Ned Davis Research in Venice, Fla., now stands at about 67% -- near the high end of its range. That figure in the past has led to pullbacks of 7% to 10%, says Tim Hayes, global equity strategist at the firm. "It's likely that a correction will take place" this month, he says.

Indeed, September and October are historically the market's worst months. Since 1945, the Dow has posted the worst returns in September, down an average of 0.81%, and has eked out a positive performance only 41% of the time since 1900, according to ISI Group, a broker-dealer and research firm. And October has seen some of the worst crashes in history. One reason for the poor showing in September and October may be that corporations and analysts are often too optimistic in setting earnings estimates earlier in the year, and "as the third quarter nears its end, they're often forced to lower those expectations," says Richard J. Nash, chief market strategist at Victory Capital Management.

That could well be the case this year. The third and fourth quarters are expected to produce the strongest profits of the year, up about 15% year-over-year in the third quarter and 21% in the fourth, according to estimates from Thomson First Call. But with such high expectations, some anticipate at least a handful of negative heads-ups as we enter the earnings-warning season this month.

A correction would be healthy for the market, say most observers. "It could set the stage for a resumption and extension of the underlying major uptrend," says Merrill's McCabe. Also, trimming valuations couldn't hurt stocks. The S&P is trading at a price-earnings ratio of nearly 18, based on estimated earnings for the next 12 months, vs. the historical p-e of around 15. But that's still much lower than the p-e of 25 that reigned in 1999. Rising long-term interest rates haven't helped equity valuations. Bonds, when they offer attractive yields, are a less risky alternative to stocks. Still, Treasury yields remain low. Says Hayes: "The big risk to stocks would be for short-term rates to move up. We don't see that now."

After stocks dip, it may be time to buy. That's because once profit warnings are out of the way, some strong earnings numbers are sure to follow. Meanwhile, the best advice for the folks in Schwab's office and others may be to wait for the correction. The autumn markdown could make for good stock shopping.

By Marcia Vickers in New York

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