Is The Bull Ready To Catch Its Breath?

Valuations aren't really out of whack -- and a correction may be a buying opportunity

These days, market soothsayers are fond of saying, "Stocks have gotten ahead of themselves" -- and perhaps for good reason. Stocks have been on a tear since they bottomed out last March. The Standard & Poor's 500-stock index is up 44%, the Dow Jones industrial average has advanced 42%, and the NASDAQ Composite Index has risen an astonishing 64%. That's leading to gloomy talk that a pullback might be in store. All the same, few equity strategists consider the market overvalued -- even at today's lofty heights.

A pullback, say experts, is just what the market needs right now to temper investor giddiness, bring highfliers down to earth, and set the stage for some smart buys before the rise resumes. Even now, valuations aren't completely out of whack, although some pockets of the market look overheated. The S&P 500 is trading around 20 times estimated earnings over the next 12 months. True, that compares with a long-term average of about 15. But it means that price-earnings ratios are back to the levels of five years ago, before the market's end-of-the-century bubble. Also, with interest rates at 45-year lows, low inflation, and rock-bottom bond yields, somewhat higher valuations are justified. Says Jack Caffrey, private client equity strategist at J.P. Morgan Private Bank (JPM ): "Though stocks aren't as robust as they were a year ago, they remain the preferred asset class." Indeed, some models show that with rates so low, average price-earnings ratios could rise as high as 25 before the market is fully valued.

That doesn't mean some sectors aren't richly priced, especially tech. The 100 largest NASDAQ companies are trading at 35 times this year's expected earnings. And tech stocks are red-hot again. According to a Smith Barney study of the 50 largest actively managed U.S. equity funds, tech was the most highly represented sector, with holdings increasing 44% since last June. "Investors have already loaded up the tech wagon," says Tobias M. Levkovich, chief U.S. equity strategist at Smith Barney (C ).

Small-cap companies also fall into the heady category. Indeed, many small companies with scant or no earnings -- "lower-quality stocks," in Wall Street parlance -- have been the top performers over the past year. Meantime, solid blue chips with consistent earnings and dividend payouts have lagged -- making them potential buys. The Russell 2000, a small-company index, is trading at around 30 times expected earnings. But as long as the economy continues to improve and interest rates stay near today's levels, strategists wager that any market correction would give way to a rebound.

PULLBACK TO BOUNCEBACK. The coming months could be bumpy. Several factors support a pullback. A further rise in corporate earnings has been priced into today's quotes, so strong results from here on aren't likely to provide much extra lift. Bullish sentiment is high, another sign that stocks may be ahead of themselves. And the market hasn't had a significant retreat in almost a year. Says Levkovich: "Our view is, we're in for a pullback." He figures the market could retreat as much as 15% by this summer.

Since last March's trough, the market rocketed ahead on rising earnings, but profit growth is likely to slow. Industry analysts polled by Thomson First Call (TOC ) project S&P 500 profits will be up a healthy 12% in 2004 over last year, although that's less than an 18% rise in 2003 over 2002. One big reason: As the year progresses, it'll be harder to top last year's big profits. Says Richard Bernstein, chief U.S. strategist at Merrill Lynch & Co. (MER ): "Everybody, even the biggest of bulls, is forecasting that profits will decelerate in 2004."

Investors have also become more exuberant. That worries some analysts. The UBS/Gallup Index of Investor Optimism reported on Jan. 24 that investors were more confident about the market now than they had been in the past 22 months. Says Yale University economics professor Robert J. Shiller, who foreshadowed the 2000 tech bust in his book Irrational Exuberance: "A really prominent feature is that people don't see much downside risk right now."

RATE JITTERS. Longer-term, there's also the specter of rising interest rates. Although most strategists and economists don't expect the Federal Reserve to boost rates until late spring or early summer, or even later in the year, investors already feel jittery about the prospects. Since rates are coming off such low levels, they could have less impact on the market than some anticipate when they do rise. Still, according to RiskMetrics Group Inc., a New York-based risk management firm, certain interest-rate-sensitive sectors such as financials and materials could take a big hit from rising rates.

If the market does stage a pullback -- especially in the double digits -- there's a silver lining: It would improve valuations and diminish investor giddiness. It may also spur a shift into some of those less risky large-cap stocks with steadier earnings. "Investors have already made the quick bucks," says Woody Dorsey, a behavioral market strategist and president of Market Semiotics in Castleton, Vt. "They're going to be thinking, 'I'll settle down and get serious and get into some safer stocks."'

After that, it would be much easier for stocks to resume their upward course. A 10% or so annual gain -- the average over the long haul -- is the more likely scenario for this year. That means the market could see "a return to normalization" -- an aphorism that, like "stocks have gotten ahead of themselves," often turns out to be true.

By Marcia Vickers, with David Henry in New York and Rich Miller in Washington

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