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Can the market repeat its stunning surge? Probably not. But it's still on a roll

Want to profit from the New Economy? Invest in the New Stock Market. That may be hard to swallow, especially with the Dow Jones industrial average having gone up nearly 2,900 points over the past two years. Rather than asking which stocks or mutual funds to buy for 1997, many investors are asking whether to take the profits and run. That's pretty much what's happened in recent weeks. The Dow is off 4.7% from its high, and has fallen by 2.7% since Federal Reserve Board Chairman Alan Greenspan suggested the market was speculative.

But the market's runup makes more sense if you consider that it's fueled by the forces that are the hallmark of the New Economy: low inflation, falling interest rates, and rising corporate profits. ''It's a best-of-all-worlds scenario,'' says Scott S. Pape, a portfolio manager with $500 million in mutual funds and separate accounts at Loomis, Sayles & Co. ''And nothing suggests it's going to be much different for the next 18 months.''

STEADY ON. Don't try to time the market. Markets tend to move in big bursts, and stepping out now might mean that you miss that big move later. The major indexes will make new highs during 1997 for the same reasons they did in 1996. The economy continues to grow at a slow but steady pace, productivity is improving, and personal incomes are rising while prices are not--at least not very much.

However, stock market returns in 1997 will be far below those recorded during the past two years. Investors should expect a more modest 10% total return. The main reason for lower expectations: By most valuations, stocks are fully priced.

That isn't the sales pitch that most investors want to hear. Stocks are most alluring when they're cheap and the upside potential seems disproportionately greater than the downside risk. But full valuation isn't a reason to sell, either. ''All things being equal, you're 8% or 10% richer a year [from] now,'' says Edward M. Kerschner, the chief investment strategist at PaineWebber Inc. ''That's an average return for stocks, and it's not bad.''

Markets have a way of surprising investors, too. Fortunately, most of the surprises of the past two years have been pleasant ones. A year ago, the expectation for stocks was similarly modest, yet the market trounced the forecasts, thanks to stronger-than-expected earnings. In 1995, a surprise bond-market rally lowered interest rates nearly two full percentage points, and the stock market soared.

The big surprise of 1997? ''The markets finally recognize the very low rate of current and ongoing inflation,'' says Charles J. Pradilla, investment strategist for Cowen & Co. Lower inflation means higher stock prices. Pradilla says investors are assuming a 3.5% inflation rate in valuing stocks now, even though inflation has been running below that for seven years. Their assumption, he says, is that inflation is lurking behind every economic report. But should markets start to revalue stocks based on a 2.5% long-term inflation rate, stocks can earn double-digit returns even with single-digit earnings gains.

And there's a good chance Wall Streeters will get a positive surprise on earnings, too. Investment strategist Abby Joseph Cohen of Goldman, Sachs & Co., says that for several years now, the growth of profits of the companies in the Standard & Poor's 500-stock index has exceeded what the growth in gross domestic product would have predicted. One reason is that government expenditures as a percentage of GDP have not increased in the 1990s, and it's the private sector that's growing a lot faster than GDP numbers indicate. Another reason behind the strong profit growth is that U.S. companies have stepped up investment in overseas operations--an important component of the New Economy. Sales from those operations don't show up in GDP, but the profits flow back to U.S. corporate income statements.

NEW WINNERS. So why are profit forecasts lower? Many analysts are just lowering their sights because gains have been strong for five years. But the nature of the economic cycle has changed. In the New Economy, it's muted, far less volatile than in the past, with lower highs and higher lows than in previous periods. The reason: the economy's shift away from manufacturing and into services.

The best earnings news will likely come from small-capitalization stocks, which have lagged the big stocks in the second half (chart). The 1997 earnings forecast for companies in the Russell 2000 index calls for a 31% gain, more than twice the most optimistic reading on the S&P, says Charles L. Hill, research director of First Call Corp., which collects and analyzes forecasts. That sets up small-cap stocks to beat large-caps for the first time since 1993. ''Small-cap names are popping up all over the place in our earnings model,'' says Stefan W. Cobb, a portfolio manager at Sirach Capital Management Inc.

Whether investors opt for large-, mid-, or small-cap stocks, the opportunities will be in stocks that have demonstrated an ability to grow consistently at a faster-than-average pace. They're in such sectors as technology and financial services, and they're fierce competitors in the global market.

What may not fare well in the new economy are companies with heavy debt burdens. In a slow-growth environment, financial leverage is a hindrance, warns Richard Bernstein, director of quantitative research at Merrill Lynch & Co. ''Our investment theme is to buy companies with relatively low leverage and stable earnings.'' Bernstein says investors should search in the technology and consumer-staples sector for those plays.

Investing in today's pricey equities market carries risk. There is no tolerance for nasty surprises such as a spike in interest rates or a scary international flare-up. A serious correction could quickly clip 10% or 15% off stock prices and sorely test the staying power of millions of new investors. But as long as the underlying fundamentals of the New Economy remain intact, the New Stock Market should reward investors.

By Jeffrey M. Laderman in New York



CHART: The Dow Has Been Riding High...But Small Caps Have Been Lagging


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Updated June 13, 1997 by bwwebmaster
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