Is This Rally for Real?


Three times in the past year, the stock market has rallied, only to dive again. The whiplash seemed almost designed to prove to investors that there was no end to the bear-market mauling they've suffered for more than three years. Now, the market is rallying a fourth time, up 19% since mid-March. Time for another tumble? Probably not.

Thanks to several powerful forces, the market may be able to escape from the rut it has been stuck in since last spring. Company operating earnings continue to grow, up 15% in the latest quarter. Low interest rates are allowing companies to cut expenses and repair balance sheets, while making stocks more attractive than bonds. Tax cuts will boost returns from dividends and capital gains.

Furthermore, the latest surge is much broader than those that fizzled: The number of rising stocks on the New York Stock Exchange regularly outpaces declining ones. Says Laszlo Birinyi of money manager Birinyi Associates: "When the market has this much positive strength, I would hesitate to stand up in front of it."

LIGHTER MOOD SWINGS. Nobody will be more relieved than weary investors. A year ago, the market was midway in a painful descent from more than 1,100 on the Standard & Poor's 500-stock index to around 800 last July. Since then, it has been stuck between 777 and 963, trading below its drooping 200-day moving average until late April. It then soared above its 200-day trend and, as of May 28, was straining against the top of its trading range, at 953. Says Paul Desmond, president of market researcher Lowry's Reports: "We've seen more buying enthusiasm than any time in the past three years."

The difference in investor reaction to news is palpable, too. After terrorists bombed apartment complexes in Saudi Arabia on May 12, the S&P slipped just 0.3%. Coca-Cola Co. (KO) shares shot up 5% on May 7 on news of a higher rating from a single stock analyst. And when Tyco International announced $1.1 billion more in accounting adjustments on Apr. 30, the stock actually rose 23 cents. Says Birinyi: "The market is taking bad news very well and reacting very positively to good news."

Instead of dumping stocks at the first sign of strength, investors are jumping in. For the first time in more than a year, stock mutual funds just enjoyed their 10th consecutive week in which investments exceeded redemptions, says Thomas McManus, a strategist at Banc of America Securities (BAC) A May 27 UBS/Gallup survey of investor confidence found that 58% of investors believe now is a good time to invest -- the most since June, 2002.

NOT THE CUT? President George W. Bush's budget may be tempting investors back into the market. Sharp cuts in federal taxes mean that the current 1.7% dividend yield on S&P stocks will give the same aftertax return to high-income individuals as five-year U.S. Treasuries, which now yield 2.3%, notes economist Robert J. Barbera of ITG/Hoenig.

Theoretically, the tax cut should add 3% to 5% to stock values, says David A. Wyss, chief economist at Standard & Poor's. But with the cuts set to expire in 2008, he says, "people aren't going to swing their portfolios around for something that will disappear in five years. Most of the current rally is coming from stronger earnings numbers and continued declines in interest rates."

Indeed, the push from earnings looks set to continue. After the first quarter's 15% rise, S&P expects operating earnings to rise 17% over the full year. The market is trading at a rich 18 times those earnings, above its historical average of about 15 and 40% more than at the start of the 1990s bull market. Still, that's reasonable compared with the return from bonds. With yields on 10-year Treasuries now down to 3.4%, some analysts' models show stocks are as much as 40% undervalued compared with bonds.

SHADOW OF A BUBBLE. Of course, a lot could still go wrong. The falling dollar could prompt European investors to dump their U.S. stocks to stanch currency losses. And the rally is vulnerable if hopes for a stronger economy are dashed. Thomas P. Hirschfeld, investment strategist at money manager J.&W. Seligman & Co., warns that companies are still carrying too much capacity in labor, plant, and equipment to expand earnings much in the near future.

In addition, many of the tech stocks that have pushed the Nasdaq up 23% since Mar. 11 are the same speculative ones that caused so much grief in the past. Perma-bear Jeremy Grantham, chairman of money manager Grantham, Mayo, Van Otterloo & Co., says the rally is just a way station in a grueling bear market in which "the S&P will go back to 690 and lower. A great bubble breaking casts a long shadow."

Merrill Lynch (MER) & Co. strategist Richard Bernstein says that by bidding up tech stocks, investors are discouraging consolidation and cost-cutting among the very companies with the most excess capacity. "The data show we're still in a bubble," Bernstein says.

CANNY BUYERS. The bulls argue that the skeptics don't give the market enough credit as a leading indicator. Edward E. Yardeni, chief investment strategist at Prudential Financial (PRU), says the market is foretelling how much the new tax cuts will help the economy this year and next. "The market is back to its old self, acting as a mechanism for looking into the future," he says.

And a close look at the stocks gaining the most shows that investors are discriminating, says Joseph Mezrich, a stock strategist at UBS Warburg. Companies posting the biggest gains lately, such as utility and energy outfits, are making large investments in equipment to help them capture higher revenues in the future. Even among the techs, the market is bidding up big R&D spenders that also stand to gain future sales.

More than three years ago, investors were easily fooled as the market soared too high. Since then, bear market losses and dashed hopes have taught them to be more skeptical -- which to bullish contrarians just makes this rally all the more credible. By David Henry, with Mara Der Hovanesian, in New York


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