Should Investors Run with the Bulls?


By Amy Tsao and Heesun Wee There's no doubt Wall Street is facing a period of unprecedented uncertainty, exacerbated by the September 11 terrorist attacks. But in the weeks since those assaults, the major stock indexes have managed -- to the surprise of many -- to climb back from record lows. On the one-month anniversary of the tragedy, the Dow Jones industrial average closed at 9,410.45, not far off the index's 9,605.51 closing price on Sept. 10. Both the tech-laden Nasdaq and the broad-market Standard & Poor's 500-stock index have rebounded to above their Sept. 10 closing numbers.

Not surprisingly, some investors are suggesting that the stock market may be at or near its low point. Despite the doomsday predictions about the worsening economy and the possibility of a protracted military campaign in Afghanistan, bulls are sharpening their horns, envisioning the start of a trend. They point to a laundry list of rallying points -- including an expected economic stimulus package from Washington and the Federal Reserve's aggressive interest rate cuts this year -- that could signal a market bottom.

"I suspect strongly that this is the beginning of a new bull market," says Hugh Johnson, chief investment officer at First Albany. "All the conditions that accompany the end of a bear market and the beginning of a bull market are in place, more or less."

He may be jumping the gun. A closer look reveals a number of factors that should keep a tight lid on how high stocks can rise the next few months.

WAR-DRIVEN RALLY. Stocks have enjoyed gains not unlike those seen in the first days of trading after U.S. troops were sent to Kuwait in 1991. That's because, as was the case 10 years ago, "there is demonstrable evidence that the U.S. is doing something about an event that disrupted markets," says Kim Wallace, chief political analyst at Lehman Bros. On Jan. 17, 1991, the day Operation Desert Storm was launched, the Dow rose 34 points, going on to post an 11.5% gain through Feb. 27, 1991, the day a cease-fire was declared.

Unlike the gulf war, which ended almost as quickly as it started, this war-driven rally may not be sustainable. Says Wallace: "This time there is the expectation that it will be a drawn-out campaign."

In all probability, no one will be able to fully measure the economic effects of the September 11 attacks and the ongoing anti-terrorism war for some time. Add that to expectations of disappointing earnings and ugly economic reports over the next several months and it spells a stock market of fits and starts.

"I'm skeptical," says Peter Coolidge, head trader at Brean Murray. "We need to see more political and economic events unfold. I think investors have been reading too much optimism into the latest news,. The rally is "a hopeful sign, but it's premature to say it's conclusive proof the worst is behind us," he says. Coolidge suspects much of the recent gains can be traced to covering short-selling positions rather than genuine optimism about the economic outlook.

"TOO SOON TO TELL." Many economists believe the U.S. economy probably slipped into recession sometime in the third quarter and, barring any other negative surprises, could rebound in the first half of 2002. If that's the case, then a bottom in the stock market could come before the end of the year, says Joe Liro, equity market strategist at Stone & McCarthy Research Associates, an economic consulting group in Princeton, N.J.

"We might have a bottom, but it's too soon to tell," he says. "Would I commit money? I'd wait until we see what the technical condition looks like at the end of [October]." Before declaring a bottom, he wants to see the Dow sail past the 9,500 mark and the Nasdaq at the 1,650 level for a couple of weeks.

On the earnings front, investors are heading into the worst season in more than a decade, with dismal third and fourth quarters expected. Bleak earnings will likely keep the markets oscillating for some time. "Volatility is not going away," says David Sowerby, portfolio manager and chief market analyst at Boston-based Loomis Sayles. "As an investor, I'm prepared to experience the same, if not potentially heightened, volatility. Given the quick rise we've enjoyed the past two weeks, I am preparing myself for a scenario of two steps back before we take the next four steps forward."

STAY DEFENSIVE. By historical measures, stocks aren't trading as if they had bottomed. On a valuation basis, trailing price-to-earnings ratios for the S&P 500 are still almost 30. Compare that with a 20-year average p-e ratio of 18.5 -- and 13 during recession troughs.

"From a valuation standpoint, it implies we have further to go to the downside," says Sam Stovall, S&P's senior sector strategist. He says he has a hunch that a bottom may be near, but he still urges caution. "Our official position is that it is not the time to jump in with both feet," Stovall says. "It's time to be selective, and don't give up on defensive names like consumer staples and health care."

Upcoming economic reports could shake the market in coming weeks as updates paint a more accurate picture of the economy a month after the attacks. Data on unemployment has yet to reflect the hundreds of thousands of layoffs and lost jobs in the aftermath of the attacks. And if abysmal retail-sales figures for September are any indication, October will be just as lousy, if not more so.

LOOKING AHEAD. Although some analysts are suggesting the U.S. consumer will prove resilient, Wall Street has no historical precedents. "We don't have models for this kind of attack to guide us," says David Watt, financial economist at Bank of Montreal Nesbitt Burns, based in Toronto. "I don't think we've hit solid recovery stage yet."

Of course, the massive selling in the sessions following Sept. 17, when the market first reopened after the attacks, has been met with several bursts of buying. That suggests "declines that were symptomatic of the last stage of a bear market or capitulation," Johnson says. And as a leading indicator of the economy, the stock market could be trying to tell us something. "What counts is not the current state of affairs but what lies ahead in the first and second quarter of next year," he says.

Aggressive Washington stimulus efforts should lift the economy, but how quickly that will happen is an unanswered question. And if reports of anthrax outbreaks and government warnings about further terrorist attacks continue, it's increasingly difficult to tell how consumers will behave in the fourth quarter. Yes, those predicting the bottom have some evidence on their side, but investors should be ready to tread cautiously in what promises to be a choppy market. Tsao and Wee cover financial markets for BusinessWeek Online in New York


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