A Hangover from Dow 13,000?

Money manager Michael Farr says the sectors that have propelled the market are past their prime, and new groups will have to emerge to fuel the rally

The Dow 13,000 milestone was cause for celebration among some investors, but it left many pros scratching their heads. "Good news is being embraced and bad news is being brushed aside, and that's what makes a bull market," money manager Michael Farr quipped as he watched the Dow Jones industrial average claw above 13,100 for the first time on Apr. 25.

The 46-year-old founder and president of Washington (D.C.) investment firm Farr, Miller & Washington points out that there are three stages to any bull or bear market: denial, acceptance, and then exuberance or fear. "I don't think this is exuberance yet. I think it feels good, and it has a good buzz," he says. "But I'm feeling kind of old and stodgy because I'm thinking the hangover is really going to be ugly when it comes."

That's because the narrow rally in cyclical basic materials and energy stocks that has driven the Dow to new highs looks past its prime, Farr says. The more significant milestone will be when the Standard & Poor's 500-stock index, the broader benchmark used by many money managers, surpasses its March, 2000, closing peak of 1,527, he says (see BusinessWeek.com, 4/25/07, "The Next Market Milestone to Watch"). But that can't happen until other sectors like technology, health care, and consumer stocks take the lead. And that might be difficult given some of the pressures in the economy, particularly with consumers feeling the pinch from high energy prices and a slowing housing market.

BusinessWeek.com's Karyn McCormack spoke with Farr during the last hour of trading on Apr. 25, when the Dow hit the new milestone. Edited excerpts of their conversation follow.

What do you think of the Dow hitting 13,000?

This is better than a sharp stick in the eye. The composite of 30 industrial stocks making new highs is a good thing; it's just not remarkably significant. The more important number is the S&P 500. We're at 1,495 today, so it's 3.6% off the all-time [intraday] high of 1,552 back in 2000. It will be a stronger, more meaningful sign for the markets when the broad S&P 500 representing 500 different companies reaches and exceeds its historical highs.

I think it's important that the leadership has been relatively narrow. Certainly we see strength in the industrials as evidenced by the Dow's new highs. Broad market strength over the past four years has been led by an unlikely group of deep cyclical sectors—energy, utilities, basic materials, and telecom have driven the market advance.

Can their leadership continue?

This basic material and energy rally is long in the tooth, according to all historical numbers. It can always go higher—markets always go to excess. We always find out how high is too high after we've been there.

Do you see a change coming?

I think we'll see a rotation in leadership, but I have no idea when. I may wear out my worry beads until we get there. But we're certainly due. Large-cap growth is now in its seventh year of underperformance on the style charts.

What will it take?

It could take the Dow going through 13,000 and people saying they want to buy again. I think more sophisticated investors are seeing China hitting some speed bumps, some of which are pretty significant. Growth, even fantastic growth, has certain limits.

What about valuations?

The large-cap blue chip stocks, which have seen earnings double over the past five years and growing at a compounded rate of 13.5% per year, have not enjoyed commensurate price increases. Rather, they have seen their price-to-earnings multiples (the price that investors will pay for $1 in earnings) fall from 26 times to 16 times.

If Peter Lynch is right, blue chip stocks are very cheap. Peter Lynch's mantra was that the most significant indicator of stock price performance over time was earnings growth. So I'm not so much waiting for the market to crash, but waiting for leadership to shift back to the more traditional sectors and shares. By that, I mean technology, health care, and some of the consumer stocks.