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HOW WORRIED SHOULD YOU BE?Is the bull run over? This jolt is enough to give investors pauseIt was bound to happen. For months now, as the blue-chip averages pushed higher and higher, support for the stock market's advance grew thinner and thinner. New highs for big-name blue chips masked the fact that the vast majority of stocks were not taking part in the bull run. Meanwhile, downward pressure on investor sentiment was mounting on all fronts: In Washington, the political heat on President Clinton was intensifying as Monicagate leaped back onto the front pages, raising nervous doubts among foreign investors. In Japan, the election of a new Prime Minister did nothing to assuage fears that there is still no end in sight to its economic crisis. On Wall Street, which had long clung to the hope that Asia's impact would be small and fleeting, as second-quarter results came in, analysts woke up to the growing severity of Asia's woes and began slashing earnings projections. On Aug. 4, the jolt came that even the most carefree investors couldn't ignore: A 299-point, or 3.4%, plunge in the Dow Jones industrial average that shaved $1.1 trillion from the total market capitalization of New York Stock Exchange issues and obliterated the gains of the past few months. SAME QUESTIONS. In one fell swoop, the stress level of a nation was sent skyrocketing. In a country where people's financial futures and the economy are increasingly tied to the stock market (page 36), and where the universe of market players ranges from cab drivers to CEOs, the questions on everyone's lips are the same: Is the great bull market over? Is this simply a normal market sell-off, or the start of a bear market? The market's performance on Aug. 5 gave little clue. The Dow took a wild ride, falling as much as 125 points, but finishing up 59 points for the day at 8547--down nearly 10% from its high, but still up 8% for the year. Ominously, though, small-cap and mid-cap issues continued their slide. How will we know if it's a correction for the bull or the birth of a bear? Over the past five years, there have been many downturns, and after each, the market shrugged and continued to race higher, scoring eye-popping gains year after year. But this time may be different. The bounce-back could take far longer--at minimum, investors may have to settle for average or subpar gains for at least a few months. This time, the market is acting against a backdrop of far greater uncertainty. Asia's woes seem to be worsening--as are the ripple effects. And now, the impact on the U.S. economy can no longer be ignored: A sharp drop in exports helped push down gross domestic product growth to 1.4% in the second quarter, stirring fears that the long economic expansion could be slowing. So, where is the market headed? The answer depends on which way you analyze the conditions. Strategists who assess such fundamental economic forces as inflation, interest rates, and basic demand are generally taking a hopeful view. The long-term picture remains healthy, even though short-term jitters can roil the markets. Technical analysts, however, remain alarmed about the structural dynamics of the market--factors such as the breadth of its advance and the numbers of new highs and lows being achieved. Earnings uncertainty makes it difficult for anybody to put a value on the overall market. Analysts have been ratcheting down forecasts for weeks. According to First Call Corp., at the start of the second quarter analysts expected third-quarter earnings to grow 11.5%. By mid-July, that number fell to 8.9%. Estimates are now being shaved a tenth of a percent a day, and the current estimate is 6.7%. No question the correction made a highly priced stock market a lot cheaper, and that is attracting some new buying. But are stocks really cheap? That depends on the level of earnings and interest rates and what method you use to relate the two (table). Right now, for instance, investment strategists at Morgan Stanley Dean Witter are forecasting operating earnings of $51 per share for the Standard & Poor's 500-stock index over the next 12 months, about a 10% gain over the number for the past 12 months. What kind of S&P price does that warrant? If you use a 5.5% yield on the 30-year Treasury bond, the fair value is 1055; bump the yield up to 6%, and fair value is 960. The long bond is now about 5.7%, which translates into a fair value of about 1000. By this reckoning, the market is nearly 8% above fair value. At the high a few weeks ago, the same calculation would have shown an S&P 500 overvalued by nearly 20%. That's not the only way to value a market, however. PaineWebber Inc. strategists argue that lower inflation justifies higher price-earnings ratios because investors keep more of what they make. Even now, ''inflation is so low that it argues for higher valuations in the stock market,'' says PaineWebber strategist Mary C. Farrell. Wage increases are more than covered by productivity gains, she says, and mounting budget surpluses in Washington will help keep inflation low. Earnings concerns are overblown, she says, because some high-profile companies were hit by lower commodity prices and Asian problems. For the second quarter, she figures that the earnings of the median S&P 500 stock is up 10%. ''We're not looking at a broad deterioration in earnings, but some definable problems,'' says Farrell. The market's most steadfast bull, Goldman, Sachs & Co.'s Abby Joseph Cohen, scoffs at the notion that stocks are overvalued. The market decline was an overreaction, she says, and stocks are now undervalued. ''We don't see any need to make revisions on the profit picture,'' says Cohen, who says the Dow Jones industrial average could reach 9300 by yearend. ''At the same time, stock prices have declined and the inflation picture looks even more favorable.'' Cohen says there has been confusion about reported earnings--which dropped 2%, according to BUSINESS WEEK (page 82). When earnings are adjusted for special charges, operating earnings for the second quarter appear to be up 5.6% for the S&P 500, she says. Some fundamental analysts, however, are worried not about inflation, but the damage that could be done by deflation. International Strategy & Investment Group's Edward S. Hyman Jr. says that the bleak situation in Asia is causing the pricing power of Group of Eight nations to take a big hit. On Aug. 3, he lowered his 1998 nominal gross domestic product forecast from 4% to 3% for the G-8, a low number by historic standards. For technical analysts, conditions in the equity markets give little reason to hope for a speedy uptick. Prudential Securities Inc.'s chief technical analyst, Ralph J. Acampora, a longtime bull, made a splashy metamorphosis into a bear during a mid-day appearance on CNBC on Aug. 4, helping speed the market's tumble that day. He said that conditions were right for the Dow to fall 20% from its high. ''I was more important than Clinton for about an hour,'' quips Acampora. His forecast translates into a loss of almost 1,900 points from the Dow's July 17 high. With the Aug. 4 fall, the market is already halfway there, down about 10% from its high. Acampora is worried not about rising interest rates but about the exposure of big-cap stocks to Asia. Still, he says, ''this is a cyclical bear market, which could last a few months, in the midst of a secular bull market.'' Why the change of heart? One technical indicator that had been making Acampora and other technicians nervous was the high level of new lows for individual stocks. To a technical analyst, that is a sign that the market has not yet bottomed out. ''Usually, when a decline is over, the new lows shrink up to nothing,'' says Mark Arbeter, chief technical analyst at Standard & Poor's Corp. BROADER RALLIES. There hasn't been quite enough gnashing of teeth to satisfy some analysts. ''One annoying factor about this drop is that it's been so orderly,'' says Barry Hyman, chief market analyst at Ehrenkrantz King Nusssbaum. ''I haven't seen the signs of capitulation.'' When the market does rally, he says, ''it will have to be a lot broader than the rallies we've had recently'' in order to last. Another indicator that still troubles market technicians is the advance-decline line (chart). The line nets out each day's number of New York Stock Exchange advancing and declining issues and adds the results to the previous day's number so the line is cumulative. Technicians say the advance-decline line has been telling a worrisome tale: The line peaked in early April, while the market kept on rising. That suggested that the market was driving higher on the backs of fewer and fewer stocks. Analysts prefer to see the market index and the advance-decline line moving in tandem. Technicians also keep a sharp eye on divergences between various sectors of the market. To them, the extent of the market's decline was no shock. The warning signals were there. One of the most striking was the divergence in performance between large-capitalization and small-capitalization indices. While the Dow soared more than 18% from Jan. 1 to July 17, the Standard & Poor's SmallCap 600-stock index lagged badly, up about 7% for the same period. Even within the big-cap universe, the ranks of rallying stocks were thin. Just 70 stocks explained the entire 1998 gain in the S&P 500 through the end of July. Also, while the Dow rose to a new high of 9338 on July 17, the number of stocks making 52-week highs did not rise, as it had in an earlier June rally. The ratio of advancing stocks to declining stocks was, in fact, steadily deteriorating. It is this ''Nifty Fifty'' development that set the market up for a fall, say some strategists. The last couple of rallies have focused on just 10 to 20 stocks, notes Barry Hyman. ''You turned these stocks from good growth companies into growth momentum issues with price-earnings ratios of up to 50, 60, even 70.'' That meant investors had to be willing to pay three to four times the stock's growth rate. And it meant the action would be driven by momentum players, whose game is to buy high and sell higher--and to get out if momentum falters. Individual investors don't seem to share the technicians' concerns. While Todd Morgan of Bel Air Capital in Los Angeles, which manages $1.7 billion, says he took lots of calls, ''the anxiety level wasn't that high. Clients just wanted to make sure that they should stay the course.'' By the end of the day, the firm had $50 million in new money earmarked for equities. Customers weren't panicking at Datek Online Brokerage Services Corp., either, and volume was normal. ''It doesn't surprise me that volume didn't pick up on a down day,'' says Alex Goor, Datek Online's executive vice-president. ''Individual investors have more faith in this market.'' Investors in the heartland also played it cool. Jud A. Powell, a broker for Edward Jones in Abilene, Tex., says he handled over a dozen buy orders on Aug. 4 for his retail clients, and no sell orders. One new element in the market brew are the developments unfolding in Monicagate. That is raising the possibility that President Clinton may find his struggles with Independent Counsel Kenneth W. Starr more challenging than anticipated. That is especially unsettling to foreign investors, who pumped $29 billion into U.S. equities in the year's first quarter, equivalent to an annualized rate of $116 billion. Americans tell pollsters they don't care much about the President's peccadilloes, but the market seems to have been at least somewhat sensitive to Monicagate. On July 28, news broke that Monica Lewinksy had been granted transactional immunity for her upcoming testimony before a grand jury. That and earnings jitters sent the stock market down 212 points before it pared the loss to 93.5 points. It continued to fall on July 29 when the White House acknowledged that Clinton had been subpoenaed. It may well be that the fundamental strategists who see this downdraft as merely a short interruption in the 15-year-old bull market will once again carry the day. And those investors who keep their cool and even view the market's drop as a buying opportunity may be the big winners a year from now. But in order for that to happen, the market will have to overcome some of the highest hurdles it's seen in a long time.
By Suzanne Woolley and Jeffrey M. Laderman in New York, with bureau reports RELATED ITEMS
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Updated Aug. 6, 1998 by bwwebmaster
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