The Market's Ever-Thinner Ice


By Amey Stone Bears and bulls have been in rare agreement lately, and so far, they've both been wrong. Forecasters thought the market would remain in a "trading range" until hostilities with Iraq commenced and overwhelming U.S. force quickly turned the war into a rout. Then they anticipated a sharp rally -- the bulls a long one, the bears a short one.

What virtually no one expected is that the three-year slide in the stock market would intensify as the march toward war with Iraq has been prolonged. Yet intensify it has. In mid-January the Standard & Poor's 500-stock index traded at 930. It closed Mar. 12 at 804, a 14% drop in two months and now perilously close to its October 9, 2002, low of 777. The market is rallying on Mar. 13, but no one knows for sure when war might commence in Iraq, and more nail-biting days could

lie ahead.

"I would have thought the market would stay in a holding pattern, but what has happened instead is that this period of tremendous uncertainty over when and if we're going to war has hurt the economy and the market," says Milton Ezrati, senior economist and strategist at Lord, Abbett & Co. "There's increasing evidence that this uncertainty is more harmful than people thought."

"DOUBLE DIP IN THE AIR." That makes the most pressing problem for investors today not what the market will do after the war commences, but whether stocks will hold their ground pre-war. "The equity risk premium is now wider than ever," research boutique Trend Macrolytics noted in a Mar. 12 commentary. "Markets don't stay stretched this thin for long -- without either unstretching, or breaking."

That has ominous implications. Investment strategists have been busy lately cutting their estimates for 2003 economic growth following a surprisingly weak Mar. 7 employment report, a dip in personal spending, and rising geopolitical tensions. "A double-dip fear is in the air," Trip Jones, a Fulcrum Global Partners senior vice-president wrote to clients on Mar. 11, a day the benchmark Dow Jones industrial average dropped 172 points, or 2.2%.

For investors, this worsening economic outlook and steeper slide in equities raises the frightening possibility that investors could be in for another major market break to the downside as more and more shareholders throw in the towel.

OSAMA AND ELVIS. The latest consensus is for 2.6% inflation-adjusted gross domestic product growth in 2003, which assumes Iraqi dictator Saddam Hussein is ousted by May, but terror risks remain elevated, according to Moody's Investors Service. Growth could rise to 3.2% if the war goes well for the U.S., Saddam exits, and terror risks at home are reduced. Or it could slip to 2% if Saddam stays around and the "persistent bunker mentality" remains. "If military action worsens matters, a double-dip recession may not be that far off," Moody's worries.

Yet it's not the long-term outlook but the day-to-day worries that have consumed the market of late. For at least the past year, market action has been dominated by short-term traders. Most recently, even they have been spooked by recent volatility and unpredictability. In his mid-session commentary on Mar. 12, Prudential Securities' Bryon Piskorowski quipped: "With reports of Osama bin Laden's capture now rivaling Elvis sightings, players are becoming more reluctant to trade on rumor and innuendo." Even to traders, staying on the sidelines is looking better than ever.

To make matters worse, with Japan's stock market at a 20-year trough and European bourses nearing eight-year lows, it's becoming hard for investment strategists to argue that U.S. stocks are cheap, points out Robert Smith, president of fixed-income investment firm Smith Affiliated Capital in New York. "We're still a long way from Dow 6,400 and 'irrational exuberance,'" he says, referring to Greenspan's famous December, 1996, warning that markets were too high.

"END OF THEIR ROPE." Meantime, the remaining individual investors who have held onto battered shares may be finding they can no longer afford to wait for a rebound, argues Peter Cohan, an author and investment strategist in Marlborough, Mass. "There are more people at the end of their rope," he says pointing to increasing unemployment ranks and record levels of personal bankruptcies. Even though no data are yet available to analyze in real time who's selling these days -- individuals or institutions -- many more people now need the cash they once were willing to risk to equities.

Any further leg down in stock prices -- and the implications that would have for the economy -- would increase the chances that the Federal Reserve's policymaking committee will decide to cut rates at its next meeting on Mar. 18. The jobs figures' decline has already given Fed chief Greenspan any excuse he needs. And the Fed has stepped into the breach before when markets were verging on breakdown. Ezrati puts the likelihood of a Fed cut at 35%, but the Treasury market has already fully priced it in, says David Gitlitz, chief economist at investment Trend Macrolytics (see BW Online, 3/13/03, "Is the Market Getting Ahead of the Fed?").

Regardless of the central bank's actions in the near term, bears and bulls alike continue to believe that a rally would commence soon after hostilities with Iraq begin -- and it becomes clear the U.S. can dominate. From there, bulls (the few that remain) think a rally could take hold. Oil prices should drop, consumers should start spending again, and business confidence would return. The bears, on the other hand, think an upswing would be brief as underlying problems in the global economy that have nothing to do with Iraq -- like overcapacity in the tech industry, deflationary pressures created by China's booming export economy, and a tapped-out U.S. consumer -- would keep weighing on stocks.

The bottom line is that investors should be braced for continued sharp volatility in the coming weeks. Not only is growing fear and uncertainty raising the possibility of a steep drop before military action starts but the strength and duration of a post-war rally is being increasingly questioned. Even professional traders are realizing that in a market too hot to handle for all the wrong reasons, seeking shelter is probably the coolest bet these days. Stone is an associate editor of BusinessWeek Online and covers the markets as a Street Wise columnist and mutual funds in her Mutual Funds Maven column


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