Stocks: Ready for Better Times?

The financial crisis isn't over, but by several measures investors are letting go of their worst fears

Lately, Wall Street feels like a less anxious place. No, the credit crisis isn't over. An optimist is still hard to find. But ever since the terrifying collapse and dirt-cheap buyout of Bear Stearns (BSC) on Mar. 17, the tension and fear that wracked U.S. financial markets have gradually eased.

Consider the evidence: With panic subsiding and the markets relatively quiet, many investors have sold their super-safe government debt. The yield on the two-year Treasury note, which started April at 1.55%, recently hit 2.461% on Apr. 25. That suggests money is flowing from safe, low-yield assets to riskier investments with more upside.

Among the riskiest equities these days are financial stocks, and they've been on a tear lately. One index of financial stocks, the Financial Select Sector SPDR Fund (XLF), is up almost 16% since the Bear Stearns debacle.

Compared to big firms, small companies are seen as more vulnerable to financial and economic shocks. But the small-cap Standard & Poor's 600-stock index has jumped more than 10% since Mar. 17.

Fear of Systemic Risk

"It's clear the markets do feel better," says Quincy Krosby, chief investment strategist for The Hartford. That doesn't mean another big piece of news can't come along and shake up the market, she adds. After months of crisis conditions on Wall Street "you take one day at a time," Krosby says.

Indeed, there are no signs of euphoria. Stocks, represented by the broad S&P 500 index, remain down 5% so far this year and off 9% in the past six months. Corporate earnings continue to fall, and a nasty recession is a serious possibility.

John Merrill, chief investment officer of Tanglewood Capital Management says it's as if, before the Bear Stearns crisis, there were two sets of risks on investors' minds. There was normal risk and then there was systemic risk, the chance that the subprime credit crisis could, through a domino-like chain reaction, take down the entire financial system. "That kind of risk is very hard to evaluate and hedge," Merrill says. The "normal set of risks" may be serious—falling earnings, weak consumer spending—but at least investors are used to them, he adds.

The Fed Steps In

Over the past month, it has become clearer that much of the systemic risk, intensified by Bear Stearns' troubles, has been removed by quick action from the Federal Reserve, Merrill says.

The Fed arranged the sale of Bear to JPMorgan Chase (JPM), it cut interest rates deeply, and it pumped the financial system with billions of dollars of liquidity. "The Fed did heroic work during the Bear Stearns crisis," says William Rutherford, president of Rutherford Investment Management. More important, the Fed, along with lawmakers in Washington, has indicated it's willing to do far more to prop up the financial system and the deteriorating housing market.

"The Fed has indicated they're on the job," Rutherford says. "Investors have taken comfort from that. That's reduced some of the fear factor in the market."

Remaining Risks

If investors are gradually feeling less skittish, rising confidence in the Fed may be the reason. It's clear other factors—the "normal risks" Tanglewood's Merrill cites—haven't helped the market. Take corporate earnings, for example. Total earnings for the S&P 500 are expected to fall 12.6% in the first quarter, according to S&P. So far, 53.1% of S&P 500 companies' profit reports haven't managed to beat analysts' earnings estimates.

And then there are the Street's other, well-documented worries. Unemployment is almost certainly headed higher, while home prices continue to fall. Spikes in oil prices suggest U.S. consumers will have less money to spend after gassing up their cars.

Given all the risks that remain, is it really a good time to be buying stocks? More help for stocks could be coming from the Federal Reserve, which is expected to make a small cut to interest rates on Apr. 30, but then stop its rate-cutting for several months. Rutherford says that move could further ease worries in the market, and could also help strengthen the U.S. dollar and lower commodity prices.

Dealing with "Big Headwinds"

Falling oil prices would make the stock market "much happier," Krosby says, and could particularly help consumer discretionary stocks. High oil and gas prices are "serving as a formidable tax on the consumer," she says.

One attraction of equities is that prices have been pushed down so far that by now "the downside is limited" in many sectors, Merrill says. The low prices make him optimistic about stocks in the short term. But in the long term, he adds: "We have some big headwinds to deal with." For example, he thinks the housing slump could weigh on the economy until at least 2010.

Then there's a threat of more credit disruptions. If not as serious as a collapse of the entire financial system, more big losses are still possible not just from subprime mortgages, but home-equity loans, credit cards, auto loans, and many other forms of credit.

"Right now, [the market] is suggesting we're getting through this, and the economy will gain steam toward the end of the year," Krosby says. But, she adds: "The market can be wrong."

Investors might be resting a bit easier than they were in mid-March. But it could be a while before they get a good night's sleep.

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