Five Sparks for a Stock Market Comeback

What will keep equities on the upward path? BusinessWeek looks at the factors necessary for a sustainable rally

Even in the midst of the biggest drop in nonfarm payrolls in 34 years, (, 12/5/08), major U.S. stock indexes rallied on Dec. 5 and extended their gains on Dec. 8. Though the November employment report was grim, investors appeared to be emboldened by President-elect Barack Obama's promise over the weekend to deliver the biggest government stimulus package seen in 50 years to get the economy moving again.

While stocks have had periodic up-moves in the past few months, efforts to foster a sustainable rally have come up short. The ever-present financial crisis ensures there's always a fresh batch of grim headlines to dash any hopes that stock prices are close to reaching a bottom. The lack of upward momentum is likely to persist now that the U.S. is mired in a recession that, according to a report released last week by the National Bureau of Economic Research, began a year ago and is projected to be the longest and deepest since 1982.

Still Some Hesitation

Since July 2007, five days is the longest winning streak the large-cap benchmark Standard & Poor's 500 index has been able to muster before succumbing to selling pressure and heading lower again. The market is well off the 11-year lows of Nov. 20, when the S&P 500 closed at 752.44, and investors seem ready to dive back into stocks. But maybe not totally ready. They're hesitating amid concerns about how long and deep the global recession will be, says Alec Young, equity strategist at Standard & Poor's Equity Research. (S&P, like BusinessWeek, is a unit of The McGraw-Hill Companies (MHP).) The consensus among economists is for the downturn to end in the middle of 2009, but most investors remain dubious.

"The market will usually look ahead six months. The reason rallies can't get any traction is there's still a lot of skepticism" about whether the timetable for a recovery will have to be extended, he says.

There's more than mere psychology at work here, even though to most casual observers of Wall Street the off-the-charts volatility defies logic, Young says. The trading is all a bet on when corporate earnings can be expected to improve. Investors' willingness to nibble at stocks at prices above the November lows suggests investors are ready to look to better days ahead.

In the meantime, though, danger lurks, especially with risks to the continued viability of the U.S. auto sector. Investors need coaxing to overcome worries about the possibility of 300,000 to 400,000 auto and auto-supply workers being laid off in the Midwest, says Young.

Against that backdrop, what could get the stock market back on an upward path? Here, BusinessWeek presents five key factors investment strategists say are needed to send equities off to the races again.

1. No More Downward Revisions to GDP GrowthFor Alan Skrainka, chief investment strategist at Edward Jones & Co. in St. Louis, a key ingredient for investor confidence is a halt in the downward revisions to economic growth forecasts that the Federal Reserve Board and private economists have been issuing.

"If this quarter is truly the worst quarter and [productivity] will begin to improve sometime early next year, then the stock market may be close to a bottom," he says. "We can't continue to see lower and lower estimates for growth and we can't keep pushing out the time frame for recovery."

Before the bottom fell out of the market in October and November, the Federal Reserve had projected an economic recovery for the end of 2008; that prediction has now moved well into 2009. If Bernanke & Co.'s next revision is for still lower growth, it will sink investor confidence, like a company that keeps missing its earnings estimates and keeps forecasting lower profits, says Skrainka.

If predictions for a return to economic growth get pushed out to September 2009, that would postpone a stock market bottom until March, says S&P's Young. "The opportunity cost of being even a month early [on a recovery bet] in this environment can be 5% to 6%, even in blue chip stocks," he says. "People are seeing how much money can be lost so quickly. Half the losses have been in the last few months."

Bill Stone, chief investment strategist at PNC Wealth Management (PNC) in Philadelphia, says investors' sentiment could turn positive if we start to see a slower rate of decline in the economic data. "You're seeing acceleration to the downside now," with GDP currently expected to drop 5% in the fourth quarter after a preliminary reading of a 0.5% decline in the third quarter.

Merrill Lynch's (MER) prediction last week that oil prices could drop to as low as $25 a barrel next year on falling world demand feeds investor pessimism in the same way, since the suggestion of protracted weakness in the global economy doesn't inspire much confidence in corporate profits, says Young.

The way out of a recession is typically created when prices for certain items and the cost of borrowing become low and attractive enough to entice consumers into buying and borrowing again, says Abby Joseph Cohen, chief U.S. investment strategist at Goldman Sachs (GS). "I do believe this will be a thornier problem than in previous recessions," requiring more time for the automotive and housing industries to rebound.

2. An Enormous Government Stimulus PackageAs Obama's remarks over the weekend have already shown, a massive government stimulus package would help alleviate market fears about a recession dragging out. Although there was no mention of size, the President-elect's plan centers on an infrastructure program to rival the Interstate highway system of the 1950s and also calls for funds to make public buildings more energy-efficient. That includes schools, which would be modernized and equipped with new computers in classrooms.

Opinions differ as to how big the stimulus needs to be to put Wall Street back in a buying mood. The market has arguably already discounted a $500 billion package, says S&P's Young, while Robert Reich, Labor Secretary in the Clinton Administration, said last week that spending needs to be 4% of GDP, or roughly $600 billion. Quincy Krosby, chief investment strategist at The Hartford (HIG), believes the package needs to be larger than $700 billion to be meaningful.

While investors are most concerned with policies that could jump-start the economy now, investing in longer-term projects will ultimately drive more sustainable GDP growth in the future, says Abby Joseph Cohen at Goldman Sachs. And investing in infrastructure no longer means only building tangible projects like bridges and highways, but also encompasses provisions for the "information economy, like the right sort of broadband connections and making sure portions of the population that are shut out of educational opportunities have access to [Internet-based resources]."

3. An End to Redemption-Related Selling by Hedge and Mutual FundsInvestors are likely to hang back and wait until they believe the deluge of fund-driven selling on any sign of strength in the market has petered out, says Krosby. There's an estimate that hedge funds still have to raise something like $200 billion to meet redemptions by the end of December. And mutual fund managers are also under pressure to sell securities to meet redemptions.

"There's almost a Pavlovian response every day at 3 p.m. [as people wonder] 'When is the selling going to begin?' That has to stop because you need to have investors feel comfortable that buying will beget buying, not technical selling," she says.

4. Increased LendingRestarting the free flow of credit is another critical component in restoring investor confidence. A 187-basis-point drop since October in the three-month London Interbank Offered Rate (LIBOR), the rate banks charge each other for short-term lending of up to one year, and increased liquidity in the commercial paper market are signs that short-term credit has begun to loosen. But long-term lending remains stuck, says Skrainka at Edward Jones. The Fed's recent announcement that it plans to buy up to $500 billion of mortgages guaranteed by Fannie Mae, Freddie Mac, and Ginnie Mae, and another $100 billion of the corporate debt of government agencies, pushed interest rates on 30-year mortgages down three-quarters of a percentage point to around 5.50% as of early December. The 20% spread between corporate high-yield bonds and Treasury notes still needs to come down, however, he says.

Lower mortgage rates, which will give families a chance to refinance their homes and lower their monthly payments, will help unlock other credit markets, which will reignite business investing, says PNC's Stone. "Then private industry goes back to infrastructure spending, because frankly they couldn't [do that] right now if they wanted to because [companies] can't get loans," he says.

5. Tax CutsKrosby at The Hartford believes cutting corporate and consumer taxes would encourage spending and put a fire under the stock market. "I don't mean temporary tax cuts because you can't plan for how much money you have," she says. "If they are long-lasting cuts, then companies and consumers can make plans."

The goal is to spur demand on the corporate side and consumer side. Historically, tax cuts have been a significant catalyst for boosting demand, though that may not hold this time, depending on how bad businesses and consumers think the recession will get and how many jobs end up being eliminated.

A payroll holiday such as the one advocated by Democrats earlier this year could also help, she says. While campaigning for the Democratic Presidential nomination, Obama advocated a cut in the payroll tax, which finances Social Security, of up to $1,000 for middle-class households to offset the costs of not only gasoline, but also of food. Gas costs have come down considerably over the past three months, but consumer spending remains seized up amid bigger worries, such as job losses.

What to do until the pieces of a sustainable rally are in place? Until investors are convinced the catalysts are present for broader-based investing in equities, they can take some comfort in stocks whose dividends they think aren't in danger of being cut, says Krosby. "There's a worry that if profits continue to decline and aren't already discounted by the share price, that dividends are going to be cut," she says. "That's why you have investors only in companies right now that have very strong cash flow and balance sheets." In other words, investors might do well to hunker down with some high-quality names until the clouds lift.

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