This Bull Is in No Hurry


The economy is starting to stabilize, and the stock market will show a more positive tone. But investors will need to be patient because the advance may be "labored," even though the downside is limited. Such is the view of Paul Cherney, market analyst for Standard & Poor's, who blends the disciplines of both technical and fundamental analysis to produce his regular commentaries (see BW Online's Investing channel, which features his daily column).

Cherney does have considerable concern about valuations. He points out that his study encompassing all the Federal Reserve's sequences of interest rate cuts since 1914 reveals that trailing price-earnings ratios for the S&P 500-stock index are unusually high now. He adds that this explains why the market has a positive tone but is unable to put together a sustained and major climb.

As for where to invest now, Cherney likes the big-name tech stocks and some of the cyclicals -- names such as Alcoa, Boeing, Caterpillar, and United Technologies. He expects the Nasdaq to keep moving up but sees resistance developing at the 2,200 to 2,300 level.

On the issue of Enron's collapse, Cherney voices outrage at the lack of accounting principles that should be enforced by law and notes that even such a successful company as Wal-Mart can treat painting its trucks as an off-balance-sheet item. Cherney made these remarks in a chat presented Dec. 6 by BusinessWeek Online on America Online, in response to questions from BW Online's Jack Dierdorff and Karyn McCormack. Edited excerpts from this chat follow. A full transcript is available from BusinessWeek Online on AOL at keyword: BW Talk.

Q: Paul, the Dow's climb above 10,000 again had great symbolic value, perhaps, but do you think the rally will keep going?

A: A positive tone will stay in place. However, Dow resistance becomes very thick with prints above 10,450, and that runs through to 10,700. So I think bulls must exhibit patience. The downside appears limited.

Q: Besides studying your charts, you also keep track of the fundamentals. How do the market and the economy look from that standpoint?

A: We're stabilizing, and the first signs of some strength reentering the economy are showing up sporadically. Since the markets move ahead of the fundamentals, don't expect to see robust economic reports in terms of the consumer because, as I've said, the unemployment number will lag and actually will tend to tick higher in the next few months, even though the markets recognize that the seeds of recovery are taking root.

Q: So the market is anticipating an economic recovery sooner rather than later?

A: Yes. Unfortunately, though, the potential for a labored advance is real, due to the fact that valuations remain at the upper edge of the envelope. The potential for a positive tone -- but with limited gains -- is real. It would take phenomenal earnings numbers for the fourth quarter to produce a sustained uninterrupted uptrend, which at this point I don't think is likely. But [the outlook is] still positive.

Q: What's the market volume telling you? Are money managers making bigger bets now that some good economic news is coming out?

A: The volume does hint at bigger participation in the upside. Many money managers feel as if they have missed the turn and the rise, and I think that their need to show equity positions growing in their portfolios increases the odds that short-term price weaknesses will be viewed as buying opportunities, which is why I think [the] downside is limited.

Q: When stocks were sagging, a lot of people looked to the bond market. Is that wise anymore?

A: I think the past couple of days are proof positive that the upside in terms of bond prices is over. We have seen a massive allocation shift out of bonds, and much of that money has fueled the rise in stocks. I look at the 10-year bond yield, which hit a low of 4.19% on Nov. 7, and today that yield is all the way up to 5%. The bull run in bonds, I think, is over.

Q: What stock sectors -- or indeed, stocks -- look most promising from your perspective now?

A: My studies -- in terms of immediate moves higher after the kind of dislocation we experienced in September -- still point to volatile outperformance by techs and early cyclicals, the capital-goods and industrial manufacturers like Alcoa (AA), Boeing (BA), Caterpillar (CAT), 3M (MMM), United Technologies (UTX) -- stocks like those. Besides the big-name high techs.

Q: Paul, what about retail stocks? Some of them reported disappointing sales today.

A: The Gap (GPS) certainly disappointed.... Wal-Mart (WMT) posted good numbers. Everybody, though, expects Wal-Mart to beat [projections] by large margins. The retail sales area is usually a good performer at this point in the cycle, but there might be some hesitancy to put more cash in the sector, only out of fear that the consumer might be less willing to overspend due to layoff fears.

Q: What do you see as the market fallout from the great Enron (ENE) disaster?

A: I don't understand how we do not have, by law, defined principles for accounting. I am not amazed anymore by the smoke and mirrors used by companies -- and approved by accounting firms -- to make operating earnings look stellar. I'm always amazed (in a sarcastic fashion) that companies can hit earnings expectations on an operating basis to the penny, or beat by a penny, when really they're just shuffling funds on the balance sheet.

Q: So will there be a crackdown that could expose some more weak points?

A: I think there has to be, for the sake of the individual investor. If there were absolute objective rules for stating earnings, the operating earnings could still be determined by individual analysts, because I think there's real value in looking at operating earnings and discounting one-time items. But when a company like WMT considers painting their trucks as a special item, not to be shown on the balance sheet, there's something implicitly wrong with the latitude that the companies take, the liberties that they take, in deciding what's a "special charge."

Q: Should we be worried about valuations still running quite high on some of the techs?

A: Yes. But about 75% of price movement these days has to do with expectations of a turnaround. I think the upside will be labored due to valuations, but I think that a positive tone will stay in place. The one thing I would not want to see is a protracted run to the upside, which takes the Nasdaq over 2,250 to 2,300, because I would have little doubt that if that occurred in less than a month, the market would only be setting itself up for a short-term cascade lower.

Q: Is the month of December usually a seasonally strong one?

A: Yes, it is. And there's a pretty consistent pattern that lows made up until the middle of the month are often a launching point for gains into the close of the year. A lot of money managers earn their pay based upon market value of their portfolio at the end of each quarter. And many of these managers will feel compelled, I think, to maintain good pricing into the end of December at least.

Q: How does a technical analyst adjust to a shock like September 11 that couldn't possibly be foreseen on any chart?

A: I can tell you that 6 of my primary 17 indicators that are part of my models went to levels never before seen in the history of my data. Ever. So for a certain amount of time, about 10 trade days after Sept. 21, I was truly in a quandary. However, after that point, standard chart reading and a return to the bounds of normalcy for my indicators started to unfold, and that allowed me to have more confidence in my standard technical analysis of these indicators.

Q: Will the yearend tax-selling of stocks have a different texture this year because of all the paper losses people have suffered?

A: I have to think that many stocks were dumped in the week ending Sept. 21, and at this time, I don't think that tax selling will be a main driver of weaker prices. At any time, we could see a three- or five-day pullback, but ultimately I believe it would be viewed as a buying opportunity.

Q: Paul, now that the Nasdaq has passed the 2,000 mark, when do you think it will hit 3,000, if ever again?

A: Oh, it will hit 3,000 again, I bet my bottom dollar on it. The timing on that event is the big question mark. There's substantial resistance, very thick, as we get immediately to 2,200 to 2,330. But judging from the time that it took us to break from the Sept. 21 lows, hitting 3,000 might take a year to a year and a half. But we will hit it, I have no doubt.

Q: So now, how fast do you see the S&P 500 moving up -- and to what level?

A: I'm guessing that before the end of 2001 we will see prints and a close above 1,200. The problem is the valuations. However, by June we could be at 1,300, and by the end of 2002 we could be north of 1,400. These long-term guesstimates are not my forte. But the trend should be positive. Not a rocket shot, but positive.

Q: A mild recovery from a mild recession!

A: I suppose you could say that. My big problem remains valuations. Right now, the trailing p-e for the S&P 500 is 30. Something is quite different this time.

Q: Can you expand on the significance of that trailing p-e of 30 for the 500?

A: I've gone back and looked at trailing p-e's for the S&P 500 during Fed easing cycles. This particular cycle, while it has been the most aggressive in the history of the Fed since 1914, in terms of both the number of rate cuts and the short amount of time [in which] they took place, has still seen enormous valuations. This, I think, is a cause for some concern.

And also, I think it explains why we haven't seen the traditional rocket shot higher as the Fed has eased. This is why I think we're more likely to see a market which has a positive tone but is unable to put together a significant and uninterrupted uptrend.

Q: Do you think the Fed will cut rates again when they meet in December? And if so, will that cause a rally?

A: The bond market is telling me that bond traders believe the Fed's easing cycle is at or near an end. On Tuesday, Dec. 11, I think the Fed will make an insurance cut of 25 points. This has been a characteristic of the Greenspan Fed that, in either direction, they usually make one final "insurance" move. So I expect a 25-basis-point cut. And no, I don't think it will cause a big rally.

Q: Asking the question the other way around, if the Fed should start to push back up, will that hurt the market?

A: The Fed will be very reluctant to put their foot on the brakes in this economy. The biggest fuel for the techs is capital-equipment expenditures, and that's usually blossoming later in the recovery, so I think that the Fed will be reluctant, regardless of some of their standard interpretations of the employment cost index and inflationary measures, because they understand the true lag between the beginning of a recovery and when expenditures for capital investment really start to flow.

Q: Would you expect the same V-shape pattern of market movement in case of new acts of terror in the U.S.?

A: I'm of the opinion that, unless the act of terror, God forbid, produced enormous loss of life, negative price reactions will be short term -- two to three days at the most. I know nothing about the machinations of al Qaeda, but I've a feeling that they did absolutely all they were capable of in a coordinated fashion when they struck on 9/11.... I don't think that their organization is as deep as anyone fears. Limited downside is what I would expect in the event of another terrorist act.


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