A Baby Bull Could Be Stretching Its Legs


Amy Tsao Investors have one thing to be thankful for this Thanksgiving: An unexpected runup in stock prices over the past couple of months. Ever since hitting year lows on Sept. 21 -- 10 days after the devastating terrorist strikes in New York and Washington -- the Dow has bounced back some 20%, while the Nasdaq Composite has posted a 34% rally.

Market mavens like what they see. They think the romp reflects investor confidence that an economic recovery and a subsequent return to stronger corporate profits are on the horizon. "The simple interpretation of what's going on is that the market has bought into the consensus view that with a lot of monetary and fiscal stimulus, we will have recovery early in 2002," says Bill Cheney, chief economist at John Hancock Financial Services.

So are we at the beginning of another bull market? Baby bull might be more like it. Ample evidence still suggests that the recovery might not come as fast and as robustly as giddy investors might like to think. The markets may well be experiencing a January-like surge -- normally one of the most bullish months of the year -- earlier than normal, in the lead up to the holidays. That could set the stage for another correction at the turn of the year (for more on the timing of a market recovery, see BW Online, 11/20/01, "A Pivotal Day for the Markets?").

"WELL-KNOWN TIMING." Still, enough positive signs are pointing to economic recovery sometime toward the middle of 2002, and for investors reeling from a horrible 2001, that's enough to celebrate. "It's a well-known timing relationship in which the equity market starts to rise about six months ahead of the low point of a recession," says Russell Sheldon, senior economist at Nesbitt Burns, Bank of Montreal's equity subsidiary. "History suggests that earnings visibility becomes better, too."

What's to cheer about? The Federal Reserve's aggressive campaign to cut interest rates, for one, with the easing widely expected to continue. A new fiscal-stimulus package is also being assembled in Washington. The war in Afghanistan is going surprisingly well for the U.S., as well. And American Special Forces are now on the hunt for Osama bin Laden.

October retail sales were far stronger than expected, and a dismal third-quarter earnings season is over -- with few ugly disappointments. International Strategy & Investment's Jason Trennert writes in a recent report that a huge group of companies in the Standard & Poor's 500-stock index lowered guidance in the third quarter, but as a result, more than half of them beat their lowered earnings estimates.

RISKS AHEAD. It certainly does appear that investors have climbed the proverbial wall of worry. Gruesome economic and corporate profits headlines don't seem to faze them anymore, and positive news gets them euphoric. "If nothing happens in the geopolitical arena, the second half of next year should be a pretty good year. The outlook should be fairly bright," says Joe Liro, economist and head of equity research at Stone & McCarthy Research Associates.

That's not to say, after two years of market declines, more bad things can't happen. Partisan squabbling on Capitol Hill that delays a tax cut could set the markets back anew. Clearly, the greatest danger is another terrorist attack on U.S. soil. "Obviously, there are still a lot of risks in the outlook," says John Hancock's Cheney.

Another big trouble spot could be the steady rise in unemployment, now at 5.4%. Many analysts think the jobless rate could jump to around 6% before starting to fall again. That isn't too worrisome as long as the rate doesn't skyrocket any further, Liro says. Still, even if unemployment is a lagging economic indicator, it's a good predictor of consumer spending -- which accounts for two-thirds of the U.S. economy.

COUNTING ON PERFECTION. Moreover, while recent data showed a jump in October retail sales, many fear that the increase was a fluke, and the all-important fourth quarter, normally buoyed by consumer spending around the holidays, will be a disappointment this year.

Yet, investors seem to have overcome the fear and loathing over fourth-quarter earnings, which should be abysmal. This removes a crucial psychological hurdle for the markets. The biggest worry for Phil Orlando, Value Line Asset Management's chief investment officer, is if companies disappoint more than expected. Then the rally could deflate during the fourth-quarter confession season. "We're counting on a perfect scenario. That's taking a big risk," he says.

Some skeptical analysts haven't forgotten the false rally of last April, when the markets lurched higher in anticipation of a fourth-quarter recovery, then retreated as spring and summer economic numbers offered little encouragement. Trip Jones, a vice-president at brokerage house Fulcrum Global Partners, worries that the same phenomenon could be at work now. "You're rallying but not seeing any good data yet. It takes real guts to buy right now."

GATHERING CHEER. Whether you call it guts or faith, you'll also need cash. Investors who have stayed on the sidelines since the September 11 attacks will now find stocks are pricier -- in some cases far pricier -- than they were just a few weeks back. S&P reports that its benchmark 500 index is trading at a price-to-earnings (estimated 2001) ratio of 28, much higher than the historic range of 15-20. "There's no guarantee just because the economy recovers that markets will have much upside," warns Cheney.

All true. But even those who are cautioning investors not to read too much into the rally are sounding more optimistic. "What the market is doing is clearly looking ahead into 2002 and 2003 and saying an earnings recovery will be there. But no one knows when or how strong," Orlando says.

The bottom line: If history is any guide, the stock market's behavior of late could well be a leading indicator of economic recovery. "If you have a firm stomach and longer-term perspective, you should be moving into stocks. We think it's a possibility that we're in the early stage of an expansion," says Sheldon. That sentiment is certainly getting stronger on Wall Street. Tsao covers financial markets for BusinessWeek Online in New York


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