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Stocks: Onward--and Mostly Upward


Two years into the 21st century's first bear market--and the stock market is partying like it's 1999. In fact, a fourth-quarter rally has brought about the highest returns since then--led by a 37% surge in the Nasdaq Composite Index since the Sept. 21 lows. That's hacked the tech-laden index' yearlong losses to two-thirds those of last year. The Dow Jones industrial average gained 19% in less than three months, and the Standard & Poor's 500 index climbed 8%. The recent gains in the broader market are impressive, but the Dow is still on track to lose 8% this year, and the S&P to lose 13%.

The market's new momentum is encouraging hopes for the future. But the question remains: Has the bear finally gone back into hibernation? Or will it go on the rampage again in 2002 and ruin the yearend festivities, as the market it did this summer, when a rally that began in April fizzled out? A key argument for a sustained rebound is historical precedent. Since World War II, there have been 10 bear markets, which posted average declines of 29% and lasted just 15 months. The current bear market--unleashed by the collapse of speculation in Internet stocks, a rout in business capital spending, and a plunge in profits--has lasted longer, at 19 months. And it has cut deeper, with declines in individual stocks of nearly 40% on average.

But these are exceptional times, and history is perhaps not a good guide. The economy and the nation have been gripped by unusual uncertainties, many stemming from the terrorist attacks of September 11. And earnings are still abysmal: S&P operating earnings will probably post a decline of 18.4%, the worst since the 1950s, says Morgan Stanley chief investment strategist Steve Galbraith.

Indeed, the earnings drought of 2001 surpasses those of 1982 and '91--two recessionary years in which earnings fell 17% and 12.8%, respectively. A preliminary consensus estimate of 19% lower earnings in the fourth quarter alone is the fifth decline in a row, the first time since 1969 there has been such a stretch of poor performance, according to Thomson Financial/First Call. The actual results are a far cry from the hopes of last January, when the analysts' consensus forecast for S&P earnings growth was 7% for 2001. Last year, Merrill Lynch & Co.'s former U.S. investment strategist, Christine Callies, predicted in these pages that the S&P would gain 22% in 2001.

Despite forecasts gone awry and disappointing profits, the spirits of Wall Street stockpickers and strategists are high. "The market is betting on a recovery, and we are too," says Robert C. Elliott, senior managing director at New York's Bessemer Trust Co., which oversees $35 billion. Elliott and others point to falling business inventories, which are starting to prompt new manufacturing orders. Inflation is tame, and the Federal Reserve is hell-bent on keeping rates low. The consensus forecast among analysts--although likely to be trimmed somewhat--is for a 15.3% gain in the S&P next year. "Not that it's a powerful expansion, but this is the point we should anticipate things getting better," says George Cohen, a principal at Cohen, Klingenstein & Marks, managers of $4 billion in equity assets. "We've pretty much taken care of the excesses."

Arguably, the rosy forecast for next year still puts S&P stocks trading at somewhere near 27 times trailing earnings--a price too dear for some, since historical price-earnings ratios hover around half that. Sure, "that's way above the average, but you have to go deeper," argues Gail P. Seneca, chief investment officer at Seneca Capital Management. Low inflation means investors will reap more of their nominal stock gains, while low interest rates will keep them in equities. "The real work is to find companies that can produce earnings that warrant this type of a multiple," she says.

For her money, Seneca is banking on large tech stocks such as Dell Computer Corp. (DELL) and Intel Corp. (INTC)--companies that gained market share in the downturn and will surge first in a rebound, she says. Small-cap companies with solid earnings growth and top-grade managers also make the cut, such as Jabil Circuit Inc. (JBL), an independent electronic manufacturer, and pharmaceutical outfit Biovail Corp. (BVF) Adds William H. Miller III, portfolio manager at Legg Mason Inc. (LM) and one of the few mutual-fund managers to beat the S&P 500 every year for more than a decade, the market is near bottom. "It may not be this quarter or next, but it doesn't matter. We're bullish," he says. Miller's $8.9 billion Legg Mason Value Trust fund is down 12.53% through Dec. 14, vs. the S&P's 13.86% loss.

Although the bulls appear to be stirring again, investors shouldn't count on a market moving upward in a straight line. "We are going to have a series of bull and bear markets," says Richard E. Cripps, equity strategist at Legg Mason. He forecasts average market returns of 7% in 2002. Cripps is leery about large blue chips that have high fixed costs and big restructuring challenges ahead, and he sees continued momentum among undervalued smaller stocks. Another bright note: Money market assets are at a record $2.3 trillion. As investors tire of measly 2% returns, they could dip more earnestly into stocks. If that's so, it might be enough to keep the bull running and the bubbly flowing. By Mara Der Hovanesian


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