Stocks: Stuck in the Twilight Zone

For the U.S. stock market, all the sound and fury of the past three months has signified—not much. Like a dangerous animal in a cage, major indexes have paced back and forth within the same trading range in that time.

It's not as if the market is acting calm or boring. Stocks, and especially particular stocks and sectors, can bounce wildly from day to day. But the bouncing hasn't really gotten equities anywhere. Standard & Poor's equity strategist Alec Young noted Jan. 29 that stocks are "boxed into a near-term trading range." Despite several attempts, the broad S&P 500 index can't seem to dip below 740 to 800, while it can't rise above 940 to 1,045.

A deteriorating economy and terrible corporate earnings have stopped any major rallies in their tracks. But hopes for a new Presidential Administration and for an economic recovery in the second half of 2009 have kept stocks from sinking lower.

Rates at Near Zero

So far, the federal government has provided investors with some downside protection. "Anytime there is a move from Washington, the market moves up," says Quincy Krosby, chief investment strategist at the Hartford (HIG). "Then, the gains quickly evaporate."

The Federal Reserve has slashed interest rates to near zero and the Fed's monetary committee said Jan. 28 it may buy long-term U.S. Treasuries to help heal credit markets. The U.S. Congress continues to weigh a large economic stimulus package, with the House of Representatives approving its $825 billion version of the plan Jan. 28. The Obama Administration, meanwhile, is reportedly studying the idea of a new Federal Deposit Insurance Corp.-managed "bad bank" that would buy up toxic assets from financial institutions.

Demonstrating the hopes many market participants put in the government, PIMCO bond fund manager Bill Gross offered his own prescription in his monthly note on the firm's Web site, published Jan. 29. He said the government needs to find ways to support the prices of assets like municipal bonds or commercial mortgage-backed securities.

The Wisdom of Bill Gross

At a time like this, "the benevolent hand of government is required and Keynes is reincarnated in an attempt to plug the dike via fiscal spending and imaginative monetary policies that support asset prices," Gross writes in his February outlook.

But while government help can spark optimism in the market, those gains can fade quickly. The problem is that many of the government's most important plans are still being developed. The measures that have already been implemented—such as low interest rates or last year's financial bailout—haven't yet stabilized the economy or financial system. "We need to see it happen," says Uri Landesman, head of global growth at ING Investment Management (ING). "It's one thing to debate a bill in Washington and another to see it put in action."

Moreover, many of the measures being debated are unprecedented. No one knows if they will work. "There's no proof in the pudding," says Richard Sparks of Schaeffer's Investment Research. Without knowing if these measures will be successful, investors are stuck merely hoping for a recovery.

Looking for Housing Stability

And so, many market observers see few reasons to think the stock market will break out of its box anytime soon. The S&P 500 has already fallen by almost half from its late-2007 peak. With stock valuations so low, investors don't want to miss out on bargains and a potentially explosive rally if the economy stabilizes. There is an "idea that you don't want to miss the train," Sparks says.

However, "On the upside there's no catalyst," says Dave Rovelli, managing director of equity trading at Canaccord Adams. He thinks the only lasting catalyst for a rally could be a stabilization of the housing market—something that the latest data, including a 14.7% plunge in December new home sales reported Jan. 29—suggest that could be far away.

Expect January to provide "another ugly month of economic data" says Peter Cardillo, chief market economist at Avalon Partners. Earnings reports are unlikely to provide much direction for the market either, professional investors say. The first batches of last quarter's results have been overwhelmingly gloomy. With 40% of S&P 500 results reported, S&P projects that fourth-quarter earnings per share for the index could be the lowest since 2002. Despite this, the market has been resilient.

Waiting for the Second Half

Most portfolio managers expect earnings from the first and second quarter of the year to be "dismal" as well, Rovelli says. Both he and Krosby say earnings reports might start mattering when executives are brave enough to begin forecasting results in the second half of the year. "We believe the global economic and [earnings] outlook needs to show more signs of stabilization before any lasting rally will ensue," S&P's Young noted.

The economy and earnings could take some time to reveal where they're headed in the second half of the year. In the meantime, a substitute indicator may be the credit markets. "Credit markets opening up [is] really the one thing that's required in order for equity markets to take a step up," Landesman says. And indeed, there have been some encouraging signs, including an uptick in issuance of corporate debt.

But until those signs are much clearer, investors are "sitting back [and] don't really know what [to] do," notes Landesman. That uncertainty could extend the market's stay in limbo for quite some time.

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