Chill Winds Confront U.S. Stocks

This October certainly hasn't been the harrowing month the stock market has come to expect from past experience. After all, the Dow Jones industrial average topped the 10,000 mark on Oct. 14 and stayed there for four of the next six trading days before pulling back 2.5% as of Oct. 28. But beware: It was just two Octobers ago that the Dow reached its all-time high of 14,164.63—before entering a protracted decline that accelerated into a crash a year ago.

Tim Wood, editor of The Bull & Bear Observer, a market newsletter, is convinced the current uptrend is nothing more than "a bear market rally within the context of a much longer-term secular bear market"—in other words, a bullish blip amid a long-term downturn. Wood believes that investors will recognize companies' decreased earnings power and reduction of dividends, and then react accordingly.

In his quarterly newsletter, published on Oct. 19, veteran investor Jeremy Grantham predicted that the current rally will be stopped in the first quarter of 2010 by "disappointing economic and financial data that will begin to show the intractably long-term nature of some of our problems," as profit margins narrow once the quick fix of short-term labor cuts has ended. He also forecasts a slow pullback from a 30% to 35% overpriced level for U.S. stocks once investors come to terms with the prospect of an extended period of economic torpor.

Grantham admits it's hard for him "to see what will stop the charge to risk-taking this year" and believes the Standard & Poor's 500-stock index could top his earlier prediction of 1100 later this year on a reinvesting frenzy by latecomers to the rally.

can earnings gains fuel a stocks run? Another investing bigwig, Pimco's bond guru Bill Gross, provided additional fodder for equity bears, saying that "the six-month rally in risk assets—while still continuously supported by Fed and Treasury policymakers—is likely at its pinnacle" in his monthly letter on the Pimco website.

Binky Chadha, chief U.S. equity strategist at Deutsche Bank, is more optimistic about equities over the next 15 months. Chadha expects earnings to climb, based on rising U.S. gross domestic product, and he believes a very small portion of the latest earnings gains is factored into current stock prices. Since third-quarter earnings for the S&P 500 index are roughly 10% above second-quarter levels when adjusted for seasonality, that suggests stocks still have room to run.

Now that third-quarter earnings have provided the stock market read that investors were seeking, they have reverted to worrying about how sustainable the recovery will be, says Chadha. And without another chance for earnings to influence the market until early 2010, investors will be reacting to macroeconomic signals such as the pace at which the Federal Reserve starts to tighten monetary policy, he adds.

Even the most optimistic investors acknowledge that the "wall of worry" for U.S. equities remains rather tall. What are the factors that could knock the bulls out of the game for keeps? BusinessWeek surveyed some top investment strategists to identify five key headwinds that the U.S. stock market faces:

Headwind #1: Tough Market Psychology The market has spent the last seven months moving higher without really looking backward at all. "Psychologically, it's hard to conceptualize that we could continue to do that without a pullback." says Art Hogan, chief market analyst at Jefferies & Co. (JEF) in Boston. "You have fully invested bears and very nervous bulls."

Many investment managers that have shown gains so far this year are taking money off the table in order to lock in those profits, unwilling to risk another down year after 2008, says Hogan. Long-short investors like hedge funds may be closing out their positions and holding off on new bets until the New Year, while long-only investors don't want to build on existing positions, he says.

Headwind # 2: Scarcity of New Money One sign of psychological skittishness has been an unexpectedly negative response by investors to third-quarter earnings, which in 84% of reported instances have beat analysts' forecasts, says Ryan Detrick, an equities analyst at Schaeffers Investment Research in Cincinnati. During the two preceding earnings seasons, better-than-expected earnings sparked buying, not selling.

The stock prices of Yahoo (YHOO), Intel (INTC), and Alcoa (AA) all moved higher after each reported better-than-expected earnings, but within a few days were trading lower than where they had been before the earnings bump. "That's clearly a concern," Detrick says. Amazon (AMZN) is one of the few stocks to have bucked that trend this season, he adds.

"It looks like in the near term, buyers have been exhausted," he says.

For all the millions of dollars that have moved from money market funds to fixed-income funds this year, hardly any money has been put to work in equities. Institutional investors have been participating, but there's more than $3 trillion on the sidelines, held mostly by retail investors who have yet to be convinced this rally is for real, Detrick says.

In fact, year to date, equity mutual funds have experienced net redemptions rather than net inflows, according to David Joy, chief market strategist at RiverSource Investments (AMP) in Minneapolis. That probably reflects how deeply scarred nonprofessional investors are by the past year's market trauma and how afraid they are of getting burned again.

Joy sees a disconnect in attitudes toward the market on Wall Street and Main Street. "The memory of the pain of the last 12 months is still very raw in the minds of individual investors [while] Wall Street has the ability to put the past behind it because [the attitude is] 'We have to keep moving forward,'" he says.

Headwind #3: A Dwindling Stimulus With much of credit for the nascent signs of economic recovery being given to government stimulus programs, there's a lot of trepidation about what will happen once the Federal Reserve starts to reverse its extremely accommodative monetary policy.

Investors are waiting for the Fed's policy committee meeting in early November to see if Ben Bernanke and his cohorts say anything that shows the recovery is far enough along to warrant the withdrawal of some liquidity that's been pushed into the financial system, says Joy at RiverSource.

"There's good reason to believe that if the Fed hikes rates, it believes the recovery has taken root," says Chadha at Deutsche Bank. He cites the equity rallies around the world that greeted the Australian central bank's rate hike earlier this month. (However, a rate hike by Norway's central bank may have factored into global equity weakness on Oct. 28.)

"The question is why the Fed is hiking rates? If it's because of an immediate inflation threat, that may not be good for equities, but we don't see that right now," Chadha says.

There's talk in the market that the Fed could raise interest rates as early as the spring, and that's definitely a concern, says Detrick at Schaeffers. That could hurt small- and mid-cap companies, which are least equipped to handle the increased cost of borrowing, he says.

"You need small-cap leadership for a bull market. It shows you appetite for risk is strong," he says. "Small caps and tech names led on the way up and are now are leading on the way down."

Headwind #4: Reduced Access to Credit While earnings may have surprised on the upside this quarter, the outlook for ongoing growth in corporate earnings doesn't look good if American households—which drive 70% of GDP—have less access to credit in the years ahead.

"Any [corporate] business model or investment model or consumption model that was predicated on cheap, accessible credit is going to be challenged" from now on, says Stephen Wood, chief market strategist at Russell Investments in New York.

Although the credit markets have recovered significantly, it would be very unrealistic to expect credit flows and financing to return to 2006 levels, he says.

Headwind #5: A Stronger Dollar While the trend in the greenback continues to be lower, more and more investors now believe the dollar may be fairly valued relative to the currencies of the U.S.'s major trading partners, suggesting it could rally from here, says Joy.

A stronger dollar would put a damper on U.S. stocks because it would make U.S. companies' exports less competitive and reduce future earnings. And with an estimated 40% of total revenues generated by companies in the S&P 500 index coming from overseas, a stronger dollar would make it less profitable to repatriate a lot of those revenues into dollars, he says.

But it would also work against banks and other institutions that have borrowed cheaply in dollars and reinvested in higher-yielding assets such as foreign currencies. That could hurt investor appetite for financial stocks. There's also the possibility that the dollar could rally in a further flight to safety if a major setback rocks the global economy.

Bonus Headwinds Besides these five factors, investors are also likely hesitant because economic data are looking more mixed than they did a couple of weeks ago. This week consumer confidence dropped for a second consecutive month. Mortgage applications were down 16% in September. There's also concern around pending regulatory-reform legislation that could adversely affect the health-care and financial sectors.

Even if the general outlook on stocks stays positive, it's unlikely to be a tide that lifts all boats, unlike that of the past seven months.

"We're moving into an environment that speaks for active management [of equity allocations]," says Wood at Russell Investments. "Not every company is going to be able to transition from an earnings gain into a revenue gain," since cost cuts have been the main factor behind better than expected profits.

Wood expects investors to start to discriminate more between companies that can drive sales higher and possibly even raise prices in 2010 and those that can't.

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