BUSINESSWEEK ONLINE : AUGUST 30, 1999 ISSUE
FINANCE

The Market Has Two Faces
The bulls see rosy corporate earnings, the bears rising interest rates. Who's right?

Summertime, and the living is easy...that is, if you're currently a bear. The Dow Jones industrial average has dropped 3.8% since its July peak. The Nasdaq Composite Index and the Standard & Poor's 500-stock index have done far worse, down 10.4% and 8.2% respectively, from their year highs. All told, more than $1.14 trillion in U.S. stock market wealth has disappeared on paper since July 16.

Bears are depending on rising interest rates to keep the correction intact. They say the Federal Reserve will raise rates to slow the economy on Aug. 24 and again in October, putting a damper on stock prices that will last at least through the end of the year. Bulls argue that they may be soon getting yet another boost from rosy corporate earnings. Even in the face of rising interest rates, say bulls, corporate profits are continuing to soar, the U.S. economy is booming, and stocks will reflect this once the current downdraft is over.

RETURN TO VALUE. Will the bears claim victory or the bulls? Perhaps neither. The force of rising rates meeting rising profits may have a neutralizing effect. It may well be that at the end of the year, the major averages don't pick up much momentum on the upside or downside. Stocks may become locked in a narrow ''trading range,'' as it's known on Wall Street. But stocks overlooked by investors--value stocks and small- and midcaps, though they've been pummeled in the last month--may outperform their larger growth counterparts despite higher rates. Small-company earnings look especially strong going forward and they are selling at considerably lower price-earnings ratios.

At least there's no arguing this: The stock market is richly valued, with the S&P 500 trading at nearly 26 times forward earnings. Indeed, even the most bullish of bulls, Goldman, Sachs & Co. Chief Investment Strategist Abby Joseph Cohen, is saying the market is now only ''minimally undervalued.'' Cohen, whose model is based on the S&P 500 vs. intermediate-term bond prices, remains unfazed by rising interest rates. ''They've already been factored into stock prices,'' she says. Cohen says that rosy corporate profits for the rest of the year are far more important than rising rates when it comes to current market valuations. ''We've seen most of the damage from interest rates, but we've not yet seen the full benefits from rising corporate profits,'' says Cohen, who predicts 7% to 8% growth in S&P 500 operating earnings by yearend.

Cohen's contention that rising rates are already built into stock prices may be right. According to a recent Salomon Smith Barney study, the threat of higher rates is swiftly priced into the market. Moreover, of the 34 times in the past decade that bond yields rose 10% or more, stocks were higher within six months 32 times and near break-even the other two.

Another bull, Thomas McManus, portfolio strategist at Banc of America Securities, says that rising rates coupled with rising profits can be good for equities. ''If interest rates are rising because of an increase in future profits, then stocks fare well,'' he says. McManus says it's a buying opportunity for some of the large-cap growth stocks that have had the wind knocked out of them. A favorite is America Online, which is 47% off its 52-week high. But McManus has a caveat: ''In this environment, a company's fundamentals better be intact.'' He believes the Internet bubble has burst and he's staying away from dot.com stocks with scant earnings.

DOOMSDAY SCENARIO. But Richard Bernstein, chief quantitative strategist at Merrill Lynch & Co., is more bearish. He says that rising interest rates are a major threat to stocks, especially the so-called ''Nifty Fifty,'' the largest 50 stocks in the S&P 500. ''The bigger the optimist you are regarding the rejuvenation of the global economy, the more you have to think rates will go up,'' he says.

Bernstein, whose quantitative models indicate the market is around 20% overvalued, thinks the glowing profits scenario also spells doomsday for large-cap growth stocks. ''When profit cycles and economic cycles are accelerating, interest rates rise and large growth issues are hit the hardest,'' he says.

There's no question that corporate profits will continue to be strong. According to First Call Corp., an earnings research firm, the second quarter should shape up well--with 92% of companies reporting earnings so far, profits are up 14.5% from last year. The third and fourth quarters look even better, says Charles L. Hill, First Call's director of research, who estimates a 21% increase in the third quarter and around 18% for the fourth. ''Business in the U.S. is very strong, but we have some easy comparisons from last year,'' says Hill.

Joseph Abbott, chief equity strategist at I/B/E/S International, is clearly in bear territory. He maintains that profits look good largely because of easy year-over-year comparisons. In addition, ''stock valuations make me queasy,'' he says. The I/B/E/S model, which compares stock earnings for the next 12 months of the S&P 500 to the 10-year bond yield, shows that the market is overvalued by 40%. Abbott says the previous valuation high was 39.8% in August, 1987, just two months before the market crash. ''These lofty heights are mostly due to overenthusiasm on the part of equity investors who are paying much more than they used to for large growth companies,'' says Abbott.

Abbott also points out that in a rising interest-rate environment, sunny corporate profits often don't give stocks the expected oomph. ''It's a bit like running in place. There's a lot of action, but you're not going anywhere,'' says Abbott. History, in fact, offers some support for his thinking. In 1994, long-term government bonds, whose prices, like those of virtually all bonds, move in the opposite direction of interest rates, suffered their second-worst loss on record. And while interest rates were rising, corporate profits were also on the rise. The S&P 500-stock index ended down 1.5% for the year, and the Dow Jones industrial average gained only 2%.

FOLLOW THE LEADER. Merrill's Bernstein reasons that large-cap growth stocks don't have the incremental growth necessary to offset the effects of rising rates. ''That's why we'll see a market leadership shift,'' he says. In fact, rising rates are largely why small-cap and value stocks did well in the second quarter of this year, with the average small-cap value mutual fund returning 18%, vs. 6.67% for the S&P 500. ''The most controversial statement we've made recently is that looking out three to five years, returns in diversified value or small-cap funds are going to be much better than Internet or technology stocks,'' says Bernstein.

And small-cap profits look good going forward, too. First Call's Hill says that Russell 2000 earnings could be on par with large-cap earnings in the third quarter. In the fourth quarter, however, he says earnings estimates for small stocks look better than those of S&P 500 stocks. Not only that, small stocks remain cheap, with the Russell 2000 trading around 18 times earnings.

Sure, investors in small-caps and value stocks haven't done well over the last few years. But by shifting into areas that can benefit from a rising rates/rising profits scenario, summer may yet turn out to be a good season for optimistic investors.

By Marcia Vickers in New York

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