Before You Dive Back into Stocks...


By Eric Wahlgren Investors on the verge of dialing up their brokers to buy stocks after the recent rally might want to fight the urge. Although the market's moves are encouraging, now may not be the ideal time to jump back in, at least not in a big way. Market strategists are predicting more pain before there's much gain.

The early March rally, which has pushed the Dow Jones industrials up 5%, the Standard & Poor's 500-stock index up 5%, and the Nasdaq Composite up 9%, isn't sustainable, they argue. The economy, corporate profits, investor sentiment, and other key factors are going to have to improve dramatically for the market to gain ground in 2002 (see BW Online, 3/6/02, "It's Still Too Early to Celebrate").

"I'm not saying that Nirvana isn't going to be upon us at the end of the year," says Bernie Schaeffer, chairman and chief executive of Schaeffer's Investment Research, a Cincinnati market research firm. "I'm just saying that a lot of things are going to have to fall into place for it to happen."

ON THE MEND? One of those things, naturally, is for the economy to get better. When it's chugging ahead again, consumers and companies will buy more Ford Expeditions and Cisco network routers, corporate profits will likely go up, and that should push stocks higher.

One recent sign that the economy may be on the mend was a Mar. 1 reading of the nation's manufacturing activity in February, which showed that the sector finally expanded for the first time in 18 months. But don't be fooled by the hype, says David Gitlitz, chief economist at Trend Macrolytics in Parsippany, N.J., another market research firm. After manufacturers spent months shedding excess inventory, it's hardly surprising that a subdued level of business activity would show up as an expansion, he says in a Mar. 5 note to investors.

"Nothing in this data as yet confirms anything more than the potentially ephemeral uptick that would be expected following the unprecedented inventory liquidation of recent quarters," says Gitlitz. A true recovery is really a ways off, adds Kevin McClintock, chief strategist and chief investment officer of David L. Babson & Co., a Massachusetts investment advisory firm. "What we are seeing right now is a short-term inventory replacement," McClintock says. "It will be long term when demand really picks up."

"STOCKS AREN'T CHEAP." The problem is, market watchers say, stocks have already built into their prices a best-case scenario for a speedy economic recovery, but a more gradual comeback seems likelier. Companies in the S&P 500 are trading on average at nearly 22 times their 12-month forward earnings, compared with 17 times before the late 1990s' boom. And companies in the tech-stuffed Nasdaq are trading at 44 times 12-month forward earnings. "Stocks aren't cheap," Jim Stanton, editor of the Low-Risk Strategy newsletter, says simply.

To justify current valuations, Stanton argues, earnings over the next two quarters would have to increase sequentially by 20% to 30%. Those chances are slim, given the economy is unlikely to blast off. First-quarter profits will probably be 11% lower than in 2001, says earnings-tracking service First Call/Thomson Financial. In the second quarter, they're expected to increase a meager 6%. "For the market to keep going, earnings would really have to jump dramatically," Stanton says. "I just don't think the market has that in it."

What's more, future corporate earnings also have to be high quality for the market to make serious headway, market observers say. That's because the accounting scandal at collapsed energy trader Enron has already spooked a lot of investors about the potential for more unwelcome surprises. McClintock estimates that 10% to 25% of S&P 500 earnings could be low quality or potentially subject to revision -- due to aggressive accounting practices or other problems. "Some earnings could evaporate," he says.

LOTS OF IFS. McClintock isn't saying more Enrons are waiting to happen. But at the very least, increased skepticism about earnings could tame buying impulses, he says, and thus hobble any market rally attempts.

For stocks to make a big move this year, a series of events would have to take place, says Schaeffer. The recovery would have to be real and would have to translate into higher corporate profits. It would help immensely if no other huge accounting blow-ups happen. And investors would have to be sufficiently impressed with companies' performance to assign valuations higher than the historically steep price tags that stocks are already carrying.

"It's almost like a chain of events has to fall into place to have the market respond more than it has already responded," says Schaeffer. It's possible, but not probable, he adds. Schaeffer, for one, is betting on another down year, with the Dow at 9,000 at yearend.

MARKET GOOSERS. McClintock, meanwhile, is expecting gains in 2002, but only in the single digits for the broad stock indexes. He expects the best returns to come from mid-cap and small-cap stocks, as their valuations tend to be not as high as those of the large-caps. And "many of them also have not adopted the aggressive accounting stances of some larger companies," he says.

Of course, other factors could come into play that might goose the market higher, says Donald Luskin, Trend Macrolytics' chief investment officer. A big tax cut might stimulate more people to work and encourage companies to make new investments. A new transformative technology could hit the scene, much like the Internet did in 1995, he says. Or newly created companies could raise hopes of new jobs and new growth.

However, the outlook for all these isn't promising. In the first two months of this year, just 10 initial public offerings were priced, the lowest total for the same period in 23 years. "None of these signs are there," says Luskin. "It's going to be a long time before people loosen up and have the risk-tolerant attitude to make real growth happen."

SIDELINED CASH. Conversely, another terrorist attack on the magnitude of the September 11 strikes on New York and Washington could stunt the market's growth, at least in the short term. "It would definitely be a negative," says A.C. Moore, chief investment strategist at Dunvegan Associates in Santa Barbara, Calif. "It would probably punctuate the improvement but not necessarily stop it."

The doom and gloom clearly won't last forever. McClintock points out that the economy is waiting for the slew of stimulative interest-rate cuts enacted by the Federal Reserve in 2001 to take effect. At the same time, lots of investor money is sitting in money markets. And once investors begin to pump it back into the market, stocks could get rolling again. "The ton of money built up in money markets is not going to stay earning 1.75% for a long period of time," he says.

At some point, the stock market will head up again for a long run. It probably won't be anytime soon though. Wahlgren covers financial markets for Business Week Online in New Y


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