Stocks: Buying on the Dips

Nobody expects this October to bring economic news to rival last year's house of financial horrors, but that doesn't mean most investors aren't jittery about little setbacks that can creep out from the shadows and drive stock prices lower.

Since the Standard & Poor's 500-stock index hit an intraday peak of 1,080.15 on Sept. 23, 2009, almost 60% above the Mar. 9 low, a wave of disappointing economic data has spooked investors. On Sept. 30, a drop in the Chicago Purchasing Manager's Index from 50 to 46.1 and news that private employers cut 180,000 more jobs in September briefly pushed the S&P 500 index down 1.3%, while a 23% plunge in auto sales from August to September caused the broader market to finish 2.6% lower on Oct. 1.

Then a bigger-than-expected 263,000 decline in nonfarm payrolls for September, along with a rise in the unemployment rate to 9.8%, almost sparked another sharp sell-off on Oct. 2, but all three major equity indices rebounded from their lows to finish no more than 0.46% lower on the day. That suggests investors viewed the pullback as a chance to buy some stocks at cheaper prices, says Sam Stovall, chief investment strategist at Standard & Poor's.

Waiting for the Big Dips But now that the economic waters appear more choppy and third-quarter earnings season is about to begin, are investors less inclined than they were a few weeks back to buy stocks on market dips? "A few weeks ago, [investors] were waiting for pullbacks [that didn't materialize]. They have come to be conditioned that they won't get much of a pullback, so they even do some buying on an intraday basis," says Stovall.

On a conference call on Sept. 30, Mark Arbeter, S&P's chief technical analyst, said he sees a fairly smooth climb by the S&P 500 to 1,120 by the end of 2009. That would represent a recouping of half the market losses suffered in the bear market. Arbeter expects the market to pull back 5% to 10% from there before starting to rise again.

The buy-on-dips mentality persists, but now investors will wait for bigger dips than the 1% or 2% daily declines they were being enticed by a few weeks ago, says Stuart Hoffman, chief economist at PNC Wealth Management in Pittsburgh. "If this market got down 5% from the September [peak] and continued down from there, you would have people jumping in, thinking there's value there."

A Volatile October Hoffman expects much more volatility in stock prices in October, which is already apparent in the first two trading days.

The latest disappointing economic figures have affected market sentiment given the persistent worries about the strength of the economic recovery, says Bruce McCain, chief market strategist at Key Private Bank (KEY) in Cleveland. "It's quite typical six months into a market run that you'd expect to see a major correction," he says. "With a 10% pullback, we would anticipate the market would find some sort of support and get going again."

Rob Lutts, president and chief investment officer of Cabot Money Management, says he won't be convinced the upside market momentum can't be sustained until he sees the stock market finish 5% down from its September highs. The $3.4 trillion in cash sitting on the sidelines tells him there's a tide of money that will flow into the market to prevent a significant correction. "I can't believe $3.4 trillion is in the right place today," he said. "I think it's in the wrong place, because it earns zero returns."

Fourth Quarter Under Scrutiny Most of the $500 billion that's moved from money market funds since January has gone into fixed-income funds due to compellingly low bond prices and high yields. But now that credit spreads between corporate bonds and U.S. Treasury notes with comparable maturities are so much tighter, less risk-adverse investors are more likely to put money into stocks over bonds, says Talley Leger, vice-president of U.S. portfolio strategies at Barclays Capital. His analysis shows the stock market is more likely to show strength than bonds in an improving economy, he says.

There's not much concern that mediocre earnings reports for the third quarter could spur a bigger sell-off in the equities market. Most investors realize they have to wait nine months from the bear market bottom before earnings improve meaningfully, says Stovall at S&P. That suggests the fourth-quarter results will come under greater scrutiny than the more immediate results.

Operating earnings for S&P 500 companies went from a year-over-year decline of 101% in the fourth quarter of 2008 to drops of 39% in the first quarter of 2009 and 19% in the second quarter, according to Stovall. His most recent estimate is for a 7% decline in third-quarter results from a year ago, and there are reasons to believe they will beat expectations. Not only is third-quarter gross domestic product expected to rise by 2.5% or more on an annualized basis, but oil prices were down more than 33% from the end of last year's third quarter. He also thinks the weaker U.S. dollar could boost earnings "since we estimate that about 50% of revenues for companies in the S&P 500 come from overseas operations," says Stovall.

Bide Your Time Hoffman at PNC thinks there's still room for the market to be disappointed by the tough comparisons with year-ago results given that the financial market debacle spurred by Lehman Brothers' collapse occurred late in the third quarter of 2008. That convinces him that this is "a bide-your-time [period] rather than jump-back-in-at-the-first-dip," he says.

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