Stocks: A Painful New Phase

A trader works on the floor of the NYSE on Feb. 17, 2009. Mario Tama/Getty Images

The stock market could give a nasty surprise to those investors who thought equities were already as low as they could go.

The broad Standard & Poor's 500-stock index fell below 800 on Feb. 17, dropping 4.6%, to 789.17. In the process, the market set off alarm bells on many Wall Street trading floors.

For the past few months, amid plenty of bad news, buyers have stepped in to prevent stocks from falling to their extreme lows of last November. Now technical strategists, who watch such things closely, say the markets have a downward momentum that could be tough to slow.

A close below 800 "would suggest a full test of the November lows is underway," warned Bruce Bittles, chief investment strategist at R.W. Baird.

Hope for a Rebound Fades

The level of 789 is particularly significant, says Uri Landesman of ING Investment Management (ING). "This is a very important battleground right here," he says.

It's not just technical traders who are worried. Long-term investors have been unnerved by a range of developments.

Just a few weeks ago, many portfolio managers spoke confidently of a second-half rebound for the U.S. economy. Those hopes may not have faded entirely, but few appear willing to bet money on them anymore.

"It continues to be a market that is rife with uncertainty," says Robert Siewert, a portfolio manager at Glenmede.

Brian Reynolds, chief market strategist at WJB Capital Group, says stock investors are catching onto the economic pessimism that already dominates credit markets. "There is another year of economic pain ahead," he says.

That pain is spreading fast. In fact, global developments are in many cases more alarming than those inside the U.S., says John Merrill of Tanglewood Wealth Management.

The economic output of Japan fell by 12.7% last quarter, according to data released Feb. 16. By contrast, advance data for the U.S. gross domestic product showed a 3.8% decline in the fourth quarter.

Market Balks at Stimulus, Bank Plan

To help stop the economy's slide, President Obama on Feb. 17 signed a $787 billion economic stimulus bill. Several days before, Treasury Secretary Timothy Geithner unveiled an effort to prop up the financial system.

Both fell flat with many investors. "The financial markets were not impressed with either the fiscal stimulus deal reached by Congress or the announcement of the financial rescue plan," says Deutsche Bank (DB) chief economist Joseph LaVorgna. The stimulus bill won't provide a significant boost until next year, he said, while Geithner's plan lacked details.

Markets were also rattled by parts of the stimulus bill that would limit bank executive pay, Landesman says.

"A lot of people are willing to believe good stuff is coming" from the Obama administration, Merrill says. "But there is some disappointment on what's come down so far."

Government, both in the U.S. and around the world, is a "powerful influence on equity markets," says Chad Deakins, portfolio manager of the RidgeWorth International Equity Fund (SCIIX). But investors get spooked when governments change laws and rewrite the rules.

"If people are uncertain what government is going to do, people are going to try to protect their capital," Deakins says. "I don't think you can see the market rally decisively until we have a lot more certainty about what the government is going to do."

Investors Batten Down the Hatches

But whatever Washington does, investors seem resigned to a very difficult year. The troubled auto sector will be in the spotlight, with the Big Three carmakers required to present restructuring plans to the federal government by Feb. 17.

Corporate earnings continue to tumble. With 385 of the companies in the S&P 500 having reported results, Thomson Reuters projects earnings for the index to drop 42.1% in the fourth quarter. On Jan. 1 analysts were expecting S&P 500 earnings to drop just 1.2%. Earnings for the financial sector dropped 751% from a year ago, from earnings of $5.2 billion in the last quarter of 2007 to a $33.9 billion loss last quarter.

"We're clearly in a very difficult time," ING's Landesman says. After the past year's steep declines, stocks look cheap to many. But investors are unwilling to buy until they can see a turn in the economic and earnings picture. "That's a very difficult call to make," he says.

Because of the uncertain outlook, "it's very difficult [for investors] to have a long-term perspective," Glenmede's Siewert says.

Could Housing Rally Stocks?

If there is any hope for stocks, it may be hiding in an unlikely place, the housing sector.

The National Association of Home Builders index rose one point in February, up from a record low reading of 8 last month. On Feb. 18, Geithner is slated to announce a new plan to revive the housing sector. If that plan is credible, says Miller Tabak strategist Tony Crescenzi, "the impact on financial markets could be significant."

Siewert agrees that signs of a stabilization in the real estate crisis could be a catalyst for higher stock prices. "The largest asset and the largest liability on a U.S. citizen's balance sheet is their home," he says.

Investors may be losing faith in a 2009 recovery, but eventually they may become optimistic for a rebound next year. WJB Capital's Reynolds is gloomy now, but, he says "2010 is going to be a good year." He adds: "If we can survive this year, we can begin to build on something."

The problem, though, is that Reynolds' optimism rests on prices in financial markets dropping so low that they finally become attractive to skittish investors.

And recent market action suggests stocks might have much farther to fall before wary investors will part with their money.

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