Stocks: Not Out of Breath Yet

As the Dow Jones industrial average and S&P 500 hit new highs, bulls argue there's still plenty of money on the sidelines

Investors got at least two big surprises this week: a plunge in China's stock market similar to the one that prompted U.S. stocks to dip in February (see, 5/30/07, "China Stocks Tumble Back Toward Earth") and a report that the U.S. economy barely budged in the first quarter. But instead of wallowing in the gloom, U.S. investors got even more giddy and pushed the Standard & Poor's 500-stock index and other indexes to new records. "The stock market has taken good news and bad news, and has spun it as good news," said Jay Suskind of Ryan Beck.

In the face of worries about China's overheated market, slow economic growth, falling home values, and rising gas prices, markets seem remarkably resilient these days. Why? For one thing, there's plenty of money out there waiting to get into the market (see BusinessWeek, 6/11/07, "Oh No, Not the Little Guy!"). "There is a lot of cash outstanding that investors and money managers are feeling pressure to put to work," said Eric Thorne, portfolio manager at the $2.4 billion Bryn Mawr Trust. At the same time, stock buybacks, mergers and acquisitions, including a steady stream of private equity buyouts, are pulling shares off the market.

Also, while plenty worry that a correction is around the corner, stock valuations still seem about right when compared to corporate earnings. Stocks may be at all-time highs, said Jeff Layman of BKD Wealth Advisors, but "this is what ought to be happening at a time of record corporate profitability."

Fed on the Sidelines

This was highlighted when the S&P 500 finally pushed past its longstanding March, 2000, record of 1,527.46 on May 30. Back then, S&P 500 stocks were trading at 27.8 times earnings. A crash and then a gradual recovery followed. In May, according to Standard & Poor's, the price-to-earnings ratio was about 17.

The good news is a Goldilocks economy—not too hot and not too cold—seems to be hanging around. Though the economy grew at a rate of only 0.6% in the first quarter of the year, other data suggest the economy is doing much better in the second quarter, Suskind says (see, 5/31/07, "Weak GDP Points to Stronger Q2"). And despite weakness at home, many U.S. firms are raking in profits abroad. With a weak dollar and many economies rising faster than that of the U.S., many big companies are doing quite well in Europe, Asia, and elsewhere. Market pros also are keeping a close eye on inflation and the Federal Reserve, though many expect little action from the Fed for quite some time.

After the strong run in the Dow Jones industrial average and S&P 500 (up 9.7% and 8.3%, respectively, so far this year), some pros wonder whether investors are getting too confident. That's always a worry, but John Wilson, chief technical strategist at Morgan Keegan, sees lots of signs that investors are still very cautious—which indicates that stocks could go even higher. "Right under the surface, the wall of worry is solid right now," Wilson says.

Lots to Worry About

But Thorne, though bullish over the long term, believes stocks may be due for a pullback. "Investors have gotten a little complacent here," he says. Many other market strategists have been predicting a selloff, often described as a 3% to 7% drop, for some time. Indeed, the market has gone 50 months without a correction of 10% or more.

As always, there's no shortage of things to worry about. Disruptions like geopolitical blowups in the Middle East or China's recent sell-off could hit the world economy, or companies could fail to hit earnings targets. Many are keeping an eye on the bond market: If rates go too high, financing and credit becomes more expensive, which could cool the feverish M&A and stock buyback activity that keep buoying the market. On June 1, the benchmark 10-year note yield hit a high for the year at 4.96%, up from 4.67% at the start of 2007.

Or, with summer starting, and the next round of earnings more than a month away, the markets might quiet down. Stocks could "tread water for a while" as markets consolidate recent gains, Layman says. "We don't see any big news on the horizon that could push stocks one way or another."

Even the best prognosticators say it's nearly impossible to predict stock movements over the short term. Says Wilson: "The market has an uncanny ability to prove the most people wrong."

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