BUSINESSWEEK ONLINE : MARCH 29, 1999 ISSUE
NEWS: ANALYSIS & COMMENTARY

Dow 10,000
After touching 10,000, can the Dow keep up its head pace? It may not get the same boost from falling rates again

There was scarcely time to pop the cork. For 58 seconds, on the morning of Mar. 16, the Dow Jones industrial average inched above 10,000. But the sell orders hit the Big Board immediately, and 70 points melted away. By day's end, the Dow closed at 9930, down 28. The next day, it fell back again after a modest rally and closed at 9879.

The betting is that sooner rather than later the Dow will climb above 10,000 and still be there as the closing bell rings. The June, 1999, Dow futures have already closed above 10,000 three times. ''Most of the milestones haven't been crossed in one day,'' says Ralph J. Acampora, Prudential Securities Inc.'s market technician, who was almost giddy over the Dow's brush with history. ''It's exciting, it's fun.''

TAMED INFLATION. Indeed, the long bull market that started on Aug. 12, 1982, with the Dow at 776.9, still packs a wallop--even after a heroic climb that has netted an elevenfold increase in stock prices. Better still, the fundamentals are there to keep the market aloft: a powerful domestic economy, low inflation, low interest rates, and a baby-boomer generation that is embracing equities in the hope of securing their uncertain retirement.

But it's also not likely that the next 16 1/2 years of stock market history will match the last. A good part of the upward revaluation of America's equity came from tectonic changes that smothered inflation and allowed interest rates to fall from the mid-teens to the 5% environs. So, future stock price increases will be far more reflective of a company's old-fashioned top-line growth and bottom-line performance. In other words, no more rocket fuel.

Indeed, many market watchers can give you reasons to believe that the market could stall or even falter. The big fear: the awakening of inflation and, perhaps, a new climate of rising interest rates. Even as the Dow flirted with its record, oil prices were rising (page 38).

Also, the market may need a rest. Almost no one predicted the speed of the Dow's ascent--8.5% from Jan. 1 to Mar. 15. Most of the 50 forecasters who were polled by BUSINESS WEEK in December of last year were bullish on the stock market for 1999, but only nine forecast a Dow that would hit 10,000 by midyear; 18 predicted 10,000 by yearend (page 36).

Abby Joseph Cohen--Goldman, Sachs & Co.'s investment strategist--says the story behind this sudden move is that ''the U.S. economy remains in very good condition.'' What also counts, she adds, is that ''the global economy is not quite as fragile as we thought a few months ago. Emerging Asia is stabilizing, Europe is O.K., and Latin America did not go into the deep recession that everyone feared.''

But what does Dow 10,000 really mean? For the millions of investors who have socked away their 401(k) money in index funds, the Dow has little relevance--since those funds usually track the Standard & Poor's 500-stock index rather than the Dow's 30 stocks. True, the Dow is running slightly ahead of the S&P this year, but last year the S&P trounced the Dow, 26.7% to 16.1%. ''The significance of Dow 10,000 is not great,'' says investment strategist Stuart T. Freeman of A.G. Edwards & Sons Inc., ''but it does have a positive psychological effect when we achieve this sort of benchmark.''

But while investors in small- and mid-cap stocks may welcome a psychological lift, they'd probably rather see their stock portfolios rising. Although the Dow is up 7.6% through Mar. 17, the S&P MidCap 400 is off 6.4% and the Russell 2000, an index of small-cap stocks, is down 5.6%. ''I can't get excited when so few stocks are participating in the rise,'' says Anthony F. Dwyer, chief market strategist at Ladenberg, Thalmann & Co.

The institutional side of Wall Street also downplays the Dow's quest for 10,000. ''It's a retail media event,'' says Charles Albers, portfolio manager of the Oppenheimer Main Street Growth & Income Fund. ''But the Dow Jones industrial average--and I emphasize the word industrial--is not a good measure of the equity market.''

Indeed, many Dow companies were leaders a generation ago but look downright dowdy in the silicon-tinged New Economy. Technology companies make up 19% of the S&P and half of the NASDAQ Composite index. The Dow 30 lacks such market leaders as Microsoft (MSFT) and Intel (INTC)--the first and third largest companies by market capitalization.

GOOD JOB REPORT. The last technology company admitted to the Dow was Hewlett-Packard Co. (HWP) in 1997. And with its mediocre bottom-line and stock performance since then, it hardly represents the dynamic expansion in high-tech. The only other tech stock in the Dow is IBM (IBM).

Despite all that, it's still the Dow that everybody from cab driver to captain of industry quotes. So, what is its latest push telling us? Most obviously, the Dow's record reflects a rosier consensus about the U.S. economy. In early March, the Dow seemed stuck at around 9300, struggling against an unfriendly bond market. Long-term interest rates had been inching up since New Year's, especially when the Commerce Dept. reported that the economy grew at a blistering 6.1% rate in the fourth quarter. But that was offset by the Labor Dept.'s best-of-both-worlds report on employment: strong job growth to buoy the consumer side of the economy, and slowing wage growth to allay fears of inflation.

The Dow came roaring back with a vengeance, up 460 points to a new high of 9736 in just two days, paving the way for the drive to 10,000 that started on Mar. 12. Leading the charge were such consumer-oriented stocks as American Express (AXP), Sears (S), and Citigroup (C). But the Dow also made strides with the help of Exxon (XON) and Chevron (CHV), which rallied on OPEC's call for production cutbacks to boost sagging prices. That also pushed spot oil prices higher and helped the S&P 500 hit new highs. Four of the seven best-performing stock groups in the S&P this month were energy-related.

ZIPPY NIKKEI. The oil rally may help push the Dow higher. But if it sparks inflation fears, bond yields would soon rise and equity prices would drop. Even now, there's an uncomfortable disconnect between the rapid riSe in stocks and the modest rebound in bond prices since early March. Depending on the valuation model, stocks remain as much as 27% overvalued relative to bonds. While that is not a sell signal, it suggests that stocks will not take kindly to any bad news like poor profit reports in April, when first-quarter results roll in. The last time the market was this overvalued was on the eve of last year's 20% correction.

Even if valuations are euphoric, market sentiment is not, says Bernard G. Schaeffer of Schaeffer's Investment Research Inc. in Cincinnati. He says polls of newsletter advisers show bullishness high--but not at current peak levels. Nor, in his view, does trading in index options indicate great optimism.

Foreign investors, who provided much of the fuel for the U.S. stock market in early 1998, are not overly bullish, either. ''We see more potential in Europe,'' says Martin Luley, a portfolio manager at Commerz International Capital Management in Frankfurt. And the new zip in Japan's Nikkei is also attracting capital that might have otherwise flowed to New York. Meanwhile, the flood of money into mutual funds, a staple of the bull market, has slowed. Robert Adler of AMG Data Services says that money going into equity funds is about 40% behind the 1998 rate. Laszlo Birinyi of Birinyi Associates Inc. in Greenwich, Conn., has his own informal measure of investor sentiment: media coverage. ''We haven't seen bulls on magazine covers in years,'' says Birinyi. Still, he sees the Dow hitting 12,000 by yearend 2000.

Sentiment and psychology aside, what do the fundamentals say? Stocks can make gains as long as a strong economy with low inflation persists. But the 1,100% gain that the Dow has experienced during this bull market will not be repeated in the coming decade.

That's because falling interest rates have a powerful multiplier effect on stock prices. Edward M. Kerschner, PaineWebber Inc.'s investment strategist, estimates that an average stock that traded with a price-earnings ratio of 8 or 10 with rates at 14% could command a 22 to 25 p-e under today's rate environment. If inflation remains tame, there's room for interest rates to come down some more. But when they're already around 5%, they can't fall another 9 percentage points again.

By Jeffrey M. Laderman in New York

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