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Investors are pinching themselves, and still the Dow soars

As jaws drop in amazement all along Wall Street, the Dow Jones industrial average is making a ripsnorting run up the charts, gaining 541 points, or almost 9%, in just one month. Is this latest sprint the bull's last hurrah--or the prelude to a prosperous New Year?

Not even the best and brightest on Wall Street predicted that the Dow could move at such an astonishing pace. In fact, coming off 1995's 33.5% increase, many strategists began the year believing that the Dow would gain just 5% in 1996, well below its historical average of 10% or so a year. But even though interest rates are higher today than at the start of the year, which is usually a drag on the stock market, and the Federal Reserve Board has signaled concern about the stock market's relentless surge, the Dow in 1996 is up 27.5% as of Nov. 26, to 6528. Since the election on Nov. 5 alone, the market has rocketed 467 points. ''We're on uncharted ground,'' says Timothy R. Stives, a 20-year veteran who manages $700 million in growth stock funds for Philadelphia-based CoreStates Investment Advisers Inc. ''Few people managing money today have ever lived through a run like this during the latter stages of a long economic cycle.''

PARTY TIME. The market is celebrating an economy that seems to have perfect pitch. Inflation, at about 3%, has been lower for longer than anyone anticipated, and economists increasingly believe that the true level of inflation is lower still. Fears that the Fed will raise rates to cool off an overheating economy have dissipated as economic growth, measured by gross domestic product, slid to an estimated 2.2% in the third quarter from 4.7% in the second quarter. Consumers are confident, with preliminary figures showing the University of Michigan index of consumer sentiment at a 10-year high in November. And the stock market is enthralled by the prospect of four more years of President Clinton and a Republican-dominated Congress.

None of the 42 market seers surveyed by BUSINESS WEEK at the close of 1995 predicted anything like today's market. The highest forecast for the Dow was 6300, made by Dain Bosworth Inc.'s Robert F. Dickey. And even he admits that he thought his forecast of a 22% gain was a long shot. ''Since 1982 the market has been averaging 17%, so it wasn't totally out of line,'' he says. ''But during the year, I didn't have much confidence that we were going to go up this far.''

He wasn't alone. Many of Dickey's peers were far less optimistic. Tom Regner, Kemper Financial Services Inc.'s chief equity portfolio strategist, thought shrinking profit margins and rising interest rates would put the Dow at 4750 about now. But profit margins have remained healthy, though a bit smaller, and ''inflation has been benign, so interest rates have declined, which gives you a natural expansion in the price-earnings multiple,'' says Regner, since lower inflation means that investors are willing to pay more for future earnings. ''Throw on record cash flows into mutual funds, and boom--you're up 28%,'' he says. Barring some sort of disaster, Regner thinks inflows into equity funds, at $192.6 billion for the first 10 months of the year, will be even greater in 1997 as investors move more funds out of savings and into stocks.

HIGHFLIERS. Fund managers are already struggling to stay fully invested. CoreStates' Stives compares putting fund inflows to work to being a test pilot. ''You have to take it to the wire, and you can't blink,'' he says. ''Think of 50 of us in formation, all about to smash into the wall at the same time. We're all scared to death, but we're afraid to get out of the market.'' Stives is trying to lock in some gains before yearend by trimming technology holdings and buying utility stocks. ''Bull markets don't last forever,'' he says. ''It's time for people to inject a little rationality into all this silliness.''

As the market spirals to greater heights, investors are lavishing attention on big blue-chip stocks. The Dow is up 8.6% for the past month and the Standard & Poor's 500-stock index is up 7.8%. Meanwhile, the NASDAQ Combined Composite has gained just 4.8% and the Russell 2000 only 2.4%. ''People are saying that if I have to take the risk, I'll take it with IBM,'' says Richard E. Cripps, market strategist at Legg Mason Wood Walker Inc. in Baltimore. ''They view it as if those stocks will always come back.'' International investors, who tend to prefer blue-chip growth stocks, are helping generate ''what looks and smells like a Nifty 50 again,'' says Regner, referring to a group of large-cap stocks championed as steady growers during the late 1960s and early 1970s.

If the Fed is nervous about the Dow's rapid ascent, it is publicly supportive of the market. Fed Governor Laurence H. Meyer notes that today's market ''doesn't have the same kind of feel as 1987, when interest rates were rising, yet the stock market was soaring, and you said, 'Whoa! How long can this go on?''' Noting the sharp decline in interest rates, with the 30-year Treasury bond dropping 75 basis points in recent months, Meyer says: ''It's hard to know exactly what fundamental value should be...but lower interest rates could buoy the market.''

''STRETCHED.'' Many market pros expect the benign interest-rate environment to continue into 1997. ''Our forecast is for the Fed to be on hold,'' says Lehman Brothers Inc. chief investment strategist Jeffrey M. Applegate. If he's wrong, it will be because a weaker economy moves the Fed to lower rates, he says.

Would the Fed raise rates to burst a possible stock market bubble? The answer, most likely, is no. ''The Fed, while watching everything, has generally been motivated by the economy,'' says John J. White, director of investment strategy for Interstate/Johnson Lane Corp. in Charlotte, N.C. ''My guess is that it would take much more speculation than we're seeing currently to get the Fed to do that.''

Besides, the market may take care of the excesses itself. There's still ''post-election euphoria,'' says Salomon Brothers Inc.'s chief market strategist, David G. Shulman. He doesn't foresee a long bear market but expects 5% earnings growth and modestly higher interest rates next year, so he figures the Dow will end 1997 at 5750, down 13%. Dickey also expects a correction, predicting that the Dow will shed 20% in 1997 before bouncing back by yearend. He says the threat of higher rates could lead to a bigger drop than people expect as higher energy prices translate into higher overall inflation.

To gain insight into the strength of the economy, strategists are paying attention to consumer spending. Retail sales slowed in the third quarter, and housing starts tumbled in September and October. But consumers are confident. ''We're dealing with a mentality that's very bullish, and I don't see that changing,'' says Cripps. ''The market is stretched in terms of valuation. There is a correction in there, but unless I predict higher interest rates

or inflation, where does it come from?''
Over the past few years, the investing public's belief in the Dow's resiliency has been amply rewarded. While the market is undeniably due for a breather, the fundamentals remain strong. Some growling is in order, but there's no full-grown bear lurking around the corner.

By Suzanne Woolley in New York, with Dean Foust in Washington


CHART: How Now?


TABLE: Meyer on the Economy

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Updated June 14, 1997 by bwwebmaster
Copyright 1996, Bloomberg L.P.
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