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THE MARKET: IT'S NOT SO BAD, HONEST...But gurus say the highs for the year are behind usStock prices are showing all the stability of a kid on a pogo stick. They're gyrating between the fear that poorly understood forces abroad will infect the U.S. economy and the hope that the U.S. will continue to shake off the contagion, as it has to date. Fear won out on Aug. 31, when the Dow Jones industrial average tumbled 512 points. Hope claimed victory in the 288-point snapback on Sept. 1. It promises to be a long, hard slog to the end of the year, one that surely will leave few investors untouched. Does the turbulence represent a pause in the bull market--or does it signal the onset of a bear market, even a recession? Many investment pros say the odds favor the relatively strong economic fundamentals of the U.S. market withstanding the global malaise. Most also believe, however, that stocks will not hit new highs in 1998 and that there's a good chance that the market has not yet hit bottom. The challenge is figuring out what fair value should be, given such a murky earnings outlook. Investor jitters were very much on the minds of Merrill Lynch & Co. Chairman and CEO David H. Komansky and Merrill President Herbert M. Allison Jr. on Sept. 1. That morning, the pair warned Merrill employees in a memo that ''selling in the equities markets has reached an emotional stage...with further declines possible before a bottom is reached.'' That day, Merrill's quantitative strategist lowered his recommended allocation to equities from 55% to 50%. For some market-watchers, the fear runs deeper. If policymakers abroad don't take strong action, some say, the malaise will only worsen and spread, and the likelihood of it spilling over into the U.S. will increase. ''The biggest risk is if policymakers get stuck thinking inside the box,'' says Credit Suisse First Boston chief investment strategist Christine A. Callies. ''If they're too concerned with the relatively short-term issues of currency valuations and so forth, that could lead to their not doing enough to help stabilize the global situation.'' The fear that the Asian contagion will spread to Latin America and to America's trading partners in the North American Free Trade Agreement, Mexico and Canada, is a big factor in the recent market jitters. On the margin, export trade can be a swing factor for the economy, says Mitchell Held, co-manager of U.S. economic research at Salomon Smith Barney. Abby Joseph Cohen, Goldman Sachs' bullish strategist, believes the strong fundamentals of the U.S. market can offset the global weakness. She doesn't foresee a worldwide recession in 1998 or 1999 and thinks the upheaval in foreign markets will ultimately have little impact on U.S. economic growth, corporate profitability, and cash flow. On Sept. 1, she upped her recommended stock weighting to 72% from 65%. With the Dow closing at 7539 on Aug. 31, Cohen pegged the market as 12% to 15% undervalued, using a Goldman Sachs inflation-based valuation model. SKIMMING THE FROTH. With the average price of shares listed on the New York Stock Exchange sinking to $38.97 on Sept. 1, down from the high of $47.65 on July 17, a lot of froth has been skimmed from the market. Indeed, many of the models show the stock market to be a good value. Using a forecast of operating earnings of $51 for the Standard & Poor's 500 stock index, and an interest rate of 5.5% on the long bond, Morgan Stanley Dean Witter's dividend discount model shows fair value for the S&P 500 at 1055--or about 6% above its Sept. 2 level. And with the long bond yield now at 5.3%, the market may be undervalued by about 11%. The trouble with such models: They don't fully capture all the things that affect stock and bond prices, such as bonds' safe haven status today. ''Our valuation model can't judge a flight to quality,'' says Brian F. Rauscher, U.S. investment strategist at Morgan Stanley Dean Witter. Less bullish strategists than Cohen lay out a convincing scenario for weaker corporate earnings. In fact, earnings-growth estimates for the third quarter have slid from 8.6% on July 17, when the market peaked, to 3.2% on Sept. 1, according to First Call Corp. Their gloomy scenario: A spreading global meltdown that keeps stocks volatile, shakes consumer confidence, and curbs consumer spending. Prudential Securities Inc. strategist Greg A. Smith forecasts low-single-digit profit growth in 1999, since he doesn't see much reason to think revenue growth will expand with pricing power so weak worldwide. But a drag on earnings may be offset by a boost from lower interest rates. If the stock market doesn't regain more ground soon, it could start cutting into expectations for economic growth. Down markets tend to slow consumer spending. Held says that if the U.S. stock market drops 10% and stays at the lower level for a prolonged period, the gross domestic product will be 0.7% lower than it would have been otherwise. The Dow has suffered a 17% drop from its mid-July peak. If a 20% correction dug its heels in, all else being equal, ''you'd probably end up with below-trend GDP growth for 1999,'' he says. The trend for growth is 2% to 2.5%. Some technical analysts see signs of a bottom. Ronald E. Elijah, portfolio manager of the Robertson Stephens Value + Growth Fund, points to an indicator tracked by Merrill Lynch's Richard McCabe. It shows the number of stocks on the New York Stock Exchange trading above their 200-day moving average. After peaking at 80% in late 1997, the reading fell below 19% the week of Aug. 24. According to McCabe, history shows readings near or below 20% to be ''a deep oversold condition for the market, which can be one ingredient for a major bottom.'' Elijah is reassured by that--but isn't ready to buy yet. ''I want to let things settle down,'' he says. ''In such a frantic period, you can make so many mistakes.'' Neither the bull nor the bear camp is likely to declare victory soon. In coming weeks, the market will react to third-quarter pre-announcements, which tend to be negative. In such an unsettled environment, investors can count on only one thing: They won't be bored.
By Suzanne Woolley in New York RELATED ITEMS
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Updated Sept. 3, 1998 by bwwebmaster
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