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The Amazing Ride Isn't Over Yet


Cover Story: WHERE TO INVEST: STOCKS

THE AMAZING RIDE ISN'T OVER YET

Dazzling the bulls and confounding the bears, the U.S. stock market has steadily climbed to heights that only six months ago seemed unreachable. The Dow Jones industrial average, at 4485, has zoomed nearly 17% so far this year, with the broader Standard & Poor's 500-stock index keeping pace. It's no mystery why: The Federal Reserve's yearlong campaign to slow economic growth without causing a recession--the "soft landing"--seemed to be falling into place. Long-term interest rates tumbled, while corporate profits continued to exceed expectations.

But in recent weeks, as evidence of the slowing economy--sluggish auto and new-home sales, declines in industrial production, and a far-worse-than-expected employment report--continued to mount, investors have begun to wonder whether the economy might have a hard landing. "In the coming weeks, we're going to be hearing a lot of talk about a recession and a bear market," warns Byron R. Wien, U.S. equity strategist at Morgan Stanley & Co. Wien doesn't think either will come to pass, but the anticipation of both, he believes, will be enough to roil the stock market and shave several hundred points off the Dow.

LOST GROUND. Indeed, a correction is overdue. The Dow hit a low of 3675 on the day before Thanksgiving, gained 160 points by New Year's--and has shot up more than an additional 650 points since then. All of it came without so much as a 3% pullback. And the market hasn't had a 10% correction since 1990, though the first quarter of 1994 came close.

Odds are that any correction will be short-lived: The vast majority of mutual-fund and pension-fund managers have underperformed the market so far this year, and they may well view a correction as another chance to make up lost ground. And individual investors, who increasingly buy their stocks through equity mutual funds, seem to be fairly steadfast. "The market's resiliency over the years has given investors--especially the baby boomers--the confidence to hold on," says Arnold Kaufman, editor of Standard & Poor's Outlook, an investment newsletter.

Some pros think a modest pullback will serve as a much needed reality check. "I worry that investors have become complacent about earnings," says Wien. The dramatic drop in interest rates--nearly two percentage points since their peak late last year--is the financial markets' confirmation of the slowdown in the economy. Yet data services that collect analysts' forecasts report that the ratio of upward to downward revisions for this year is still nearly 2 to 1, and forecasts for 1996 are going up as well. "There may be a lot of talk about a slowdown, but you certainly don't see it in the earnings estimates," says Benjamin L. Zacks of Zacks Investment Research. Estimates are rising at a wide array of companies, while markdowns are concentrated in cyclical industries such as autos, homebuilding, and retailing.

All told, earnings forecasters are still pointing to a robust 1995 and 1996. Wall Street investment strategists, who rely on macroeconomic models to come up with profit and stock market forecasts, on average expect 1995 earnings of companies in the S&P 500 to come in at $35.47 a share, according to First Call Corp. (chart). That represents a hefty 15.7% gain over 1994. The forecast from equity analysts who follow companies in the S&P is a shade under $38, representing nearly a 24% increase over last year.

"BEST SHAPE." Of course, there are good reasons for the upbeat forecasts, especially from analysts who know the companies best. After years of massive layoffs and restructuring, U.S. industry has reduced its overhead, enhanced productivity, and learned how to compete in the global market. "I'm extremely bullish on America Inc.," says Tony Kreisel, a portfolio manager on the $11.4 billion Putnam Fund for Growth & Income. "We're in the best shape structurally we've been in for 20 years." In addition, the weaker dollar gives U.S. companies an edge in foreign markets.

Still, the newly revitalized America Inc. has yet to demonstrate that it can march through an economic slowdown without missing a beat on earnings. The first test of this may come in July, when companies begin to report second-quarter results. A few disappointments from high-profile companies could send many investors heading for the exits.

But if investors are overestimating the power of earnings, they're probably underestimating the impact of lower interest rates on stock market values. Stanley Levine, quantitative research director at First Call, uses the yield on a 10-year U.S. Treasury bond, now at 6%, to calculate a "fair value" price-earnings ratio for the market of 16.7. (He simply divides 1 by the yield.) Then he figures the p-e based on the 12-month earnings outlook by dividing the level of the S&P (now 536) by the next four quarters' earnings forecast ($37.79). That yields 14.2, which indicates the S&P is undervalued. What's a fair value for the S&P? Multiply the earnings by fair value p-e of 16.7. That puts the fair value of the index at 631, nearly 100 points higher than it is now. That's roughly 5000 on the Dow.

Think the slowing economy will force earnings down a few notches? So does Morgan's Wien, who expects 1995 S&P earnings per-share of $34. But even so, Morgan Stanley's valuation model, which uses a 30-year U.S. Treasury-bond yield, still comes up with 616 as the fair-value target. "That's why investors should ride out any correction," says Wien. "Stocks are undervalued."

That's also why investors who have missed this rally should start making a shopping list--and then buy on the pullbacks. Here are some suggestions for where to look:

Technology. Investors may be reluctant to buy tech stocks, since the group is already up 40% and tends toward sell-off in the summer. But business prospects are excellent, and analysts say leaders such as IBM, Intel, Micron, Microsoft, and Texas Instruments would be attractive on pullbacks. What's more, IBM's surprise bid for Lotus Development Corp. could trigger more takeover activity and higher prices.

For more cautious sorts, Laszlo Birinyi of Birinyi Associates suggests Baby Bells: Ameritech, BellSouth, Nynex, and Southwestern Bell. Although primarily utilities, they're rapidly expanding into new information and communications technologies. Says Birinyi: "You get nice, healthy dividends and a secondary technology play."

Financial. Falling rates are a boon to all sorts of financial stocks, and as expected, they have been great performers. But there's still money to be made. Putnam's Kreisel especially likes banks: The fundamentals are sound, deregulation and interstate banking offer new opportunities, and the banks are hiking dividends and buying back shares. Among his favorites are BankAmerica, Citicorp, Fleet Financial, J.P. Morgan, and Wells Fargo.

Retailing. With the economy slowing, you wouldn't expect to see retailers on anyone's buy list. But several investment pros think they're good bets. Strategist David G. Shulman of Salomon Brothers Inc. is wary of the stock market in general but thinks department-store operators such as Dillards, Federated, and May are smart buys. "Expectations are so low that [even] a little improvement will move the stocks," he says. Where might that come from? Foreign tourists, lured to the U.S. by the cheap dollar, will head for the stores.

Small-cap stocks. Large-capitalization stocks such as Walt Disney, Merck, and Philip Morris led the way this year. Small-company stocks have fared only about half as well. Well-managed small companies with good niches thrive in almost any economic environment. Which ones? See the story on small-cap stocks.By Jeffrey M. Laderman in New York


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