Fight or Flight on the Street
By Eric Wahlgren
The market was doing so well. From Jan. 1 to early March, stocks were up 4% as investors feted fourth-quarter 2003 profits that had jumped 28% over the previous year. The U.S. economy was growing at a healthy 4%-plus annual rate. Then on Mar. 5, investors learned just 21,000 jobs were created in February, renewing questions about the economic recovery. Less then a week later, terrorist bombings linked to the al Qaeda network killed 200 people in Madrid.
Those events triggered a stock slide that has the benchmark Standard & Poor's 500-stock index down nearly 2% for the year. On Mar. 24, stocks seemed to stabilize after a four-session losing streak fueled by fears of terrorism and a weak U.S. economy. But "March Madness" has many investing pros worried about the outlook for stocks. "We expect...the market's decline will get worse before it's over," Gail Dudack, chief investment strategist for SunGard Institutional Brokerage in New York, wrote in a recent note to investors.
Thank goodness what Wall Street cares about most -- corporate performance -- still looks good. Profits of S&P 500 companies are expected to increase 13.6% in fiscal 2004, according to earnings tracker Thomson First Call. That's not as impressive as the 18.4% jump in fiscal 2003, but it's hardly a disaster. Indeed, on Mar. 24, separate reports showed new-home sales and orders for big-ticket goods like airplanes were stronger than expected in February.
"The economic fundamentals haven't largely changed" says Joel Naroff of Naroff Economic Advisors in Holland, Pa. He blames the sell-off on investors realizing "the market had made up a tremendous amount of ground, and...[they] started asking the logical question: How do we do well from here?"
That's the question BusinessWeek Online asked a number of experts. Several pros say the recent downswing has made stocks more attractive. "This is a buying opportunity -- [though] not a screaming one," says Jeff Kleintop, chief investment strategist at PNC Advisors in Philadelphia, who adds: "We will probably see 7% to 8% upside between here and the end of the year." Perhaps. Here's what he and some others are saying about the topics most worrisome to investors:
Earnings: "We want to see expectations met or beaten," says Brian Williamson, vice-president for equity trading at Boston Company Asset Management in Boston. That's crucial, he says, as investors become wary of pricey valuations in a shaky global climate. "In this market, it will be particularly difficult to get any [price-earnings] multiple expansion, so the real driver going forward will be earnings growth," says Mark Foster, chief investment officer of Kirr Marbach Partners in Columbus, Ind.
The price-earnings multiple for the S&P 500 is currently 17.4, still slightly higher than its historic average of 15 to 16, according to Thomson First Call. Foster is moving off the sidelines and back into the market. "With this recent downward move, we have seen some names come back into our price range," he says.
The arrival of first-quarter earnings season, which gets under way Apr. 6, should take investors' minds off some of the worries, suggests Kleintop. "The market is obsessing over global insecurity, terrorism, and the lack of jobs growth because we're in a news vacuum with regards to earnings," he says. Some pros remain optimistic, despite consensus views that earnings growth will taper off over the course of the year. Second-quarter year-over-year growth is pegged at 14.7%, the third quarter at 11.7%, and the fourth quarter at 12.9%, according to Thomson First Call.
Yet Lincoln Anderson, chief investment officer of LPL Financial Services in Boston, thinks Corporate America will surprise investors by exceeding expectations. "Every quarter that comes in, consensus estimates get crushed," he says.
Jobs: Investors want "evidence the economic recovery is not fading," says Naroff. The stimulus from the Administration's income tax cuts is petering out. Jobs growth would be a signal that companies feel comfortable enough about the future to add to payrolls -- plus, it would mean more Americans with paychecks to spend. Naroff thinks companies will have to add at least 150,000 to 175,000 new jobs a month -- the minimum needed to absorb everyone who wants to work -- to boost investor confidence.
The market might really take off if 200,000 or more new jobs a month were added on a sustained basis, Naroff says. The nation's March payroll numbers are due out on Apr. 2. "Jobs growth will be key in dispelling fears that we may be losing economic traction," says Kleintop. By Eric Wahlgren Terrorism: Geopolitical concerns may not be the market's main worry, but the recent pullback has essentially been a "pricing in" of terrorism fears, says Williamson. How the market might react to another act of terrorism would depend on its severity and its effect on the U.S. economy. "If it's an attack that people perceive they can move forward from, there will be a reaction in the market, but it probably won't be long-lasting," Naroff says. All bets are off though if al Qaeda or some other group pulls off a massive deadly operation in the U.S., analysts say. "If it's a dirty bomb in the middle of Manhattan," adds Naroff, "that's a different story."
Interest rates: Borrowing costs need to remain low for the market to rally, analysts say. Ironically, a small increase in short-term rates could provide a psychological boost to investors. Typically, Federal Reserve rate hikes hurt equity prices because they raise the cost of doing business for many companies. But, "rising interest rates could be more of an indication that the economy is out of harm's way, and investors may be pleased with that," Naroff says.
Investing pros are mixed on whether the Fed would jack up rates before November's Presidential election. Some think the central bank could make the move if the jobs number started to tick up sharply. But Anderson believes rates will probably hold at a measly 1% through the rest of the year. "Inflation has been so tame," he says.
Energy prices: Oil stocks would be hurt, but the rest of the market would cheer declining energy prices, the pros say. On Mar. 22, a gallon of gas at retail pumps hit a record high average of $1.74, and Naroff notes that rising energy costs are sapping companies and consumers. "Businesses are operating in an environment in which they can't pass on cost increases, so they're being forced to eat more and more of them," Naroff says. "For consumers, it's more money that's being burned out the tailpipe or up the chimney."
Presidential election: No one is sure how this might affect investor psychology. Kleintop says stocks will probably go higher if Bush is reelected. Whether they should is a separate issue, he says, but "the market generally tends to take a negative view to a change in the Oval Office."
Others disagree. Stock market returns have averaged 5% higher under Democratic Presidents than Republican ones, says investment expert Peter Cohan, who has looked at the potential market impact of the 2004 election. Cohan cites an October, 2003, UCLA study that analyzed market performance under various Presidents between 1927 and 1999. "One of the theories of the study was that markets were systematically positively surprised by the policies under Democrats, says Cohan, president of Peter S. Cohan & Associates in Marlborough, Mass.
One thing is certain: The view held earlier by many investing pros -- that the market's biggest gains would come in the first half of the year -- doesn't look so smart anymore. Perhaps now, if terrorism fears recede, the next occupant of the White House is decided, and jobs growth picks up, the market will rally, picking up steam toward yearend. That's the view taken by Kirr Marbach Partners' Foster, who says: "We've been operating under this scenario." With only losses to show for the first three months of 2004, investors are likely hoping Foster is right.
Wahlgren covers financial markets for BusinessWeek Online in New York