Fear Also Has Its Upside


By Amey Stone There's an old Wall Street saying that markets climb a wall of worry. That's exactly what stocks are doing now. Investors have a lot to wring their hands over: a weak labor market, higher interest rates, an exploding federal budget deficit, a massive trade imbalance, and a possible quagmire in Iraq. In keeping with the maxim, the stock market is likely to keep climbing this year. After all, the more worried investors are, the more money there is on the sidelines that can be put to work to drive the market higher.

"As we come off a bottom, people never believe the rally will hold," says Jeff Mortimer, senior portfolio manager at Charles Schwab Investment Management. "Eventually they say 'uncle,' and there could be a whole other move into equities."

JOBS VS. PRODUCTIVITY. Of course, six months into a rally that has driven the Standard & Poor's 500-stock index up 27% and the Nasdaq up 45%, the tenor of the worrying has changed. Investors are starting to fret more about missing out on future gains than they are about taking on risk, says Trip Jones, a managing director in strategy and sales at SunGard Institutional Brokerage.

That means investors would need a really good reason to lighten up on stocks, and so far the economic and earnings news -- although mixed -- hasn't given them one. Sure, the labor market remains stubbornly weak. On Sept. 11, the government announced that new weekly jobless claims rose to 422,000, (any number above the 400,000 mark generally signals a deteriorating job market). That's the steepest jump since early July, according to Moody's Investors Service.

Yet productivity is soaring. In a Sept. 4 Labor Dept. report, it was revised upward 1.1 percentage points, to 6.8%. Most analysts believe strong productivity eventually leads to more jobs. It can take a while, but in the meantime it clearly leads to stronger profits, as companies get more output from the same bunch of employees.

"BUY STRENGTH." Strategists still would like to see sales pick up -- operating costs at most companies have been trimmed so much that even a small sales lift can mean a big jump in earnings. In the second quarter, operating earnings grew 9.6% over the second quarter of 2002, according to research firm First Call, and the third quarter should be much better still.

Earnings preannouncements for the third quarter are running more positive than usual, and analysts' quarterly earnings projections continue to improve. According to First Call, third-quarter profit growth forecasts are averaging 14.9%, up from estimates of 12.7% at the quarter's start in July. Third-quarter profits may ultimately come in up 19% over those of a year ago, according to First Call.

Near-term, the biggest hurdle to higher stock prices is steep valuations. The market, which bottomed in March, never got as cheap relative to earnings as it did in past bear markets. In fact, it's already starting to look expensive. The price-earnings ratio of the S&P 500 is 22 -- and some large-cap bellwethers, especially in tech, are far higher. Dell's (DELL) p-e is now 39, and Wal-Mart's (WMT) stands at 30.

However, with economic growth rates beginning to accelerate and estimates being revised up, stocks aren't likely to fall now. "Institutional investors of every stripe are anxious to buy weakness, but if push comes to shove, they are likely to buy strength," wrote Soundview Technology Group analysts in a Sept. 5 report.

JITTERS AND JUMPS. Strategists who were bearish have been issuing mea culpas. Announcing that they're now "throwing caution to the wind," Soundview analysts admitted in the Sept. 5 report that they were "guilty of getting cold feet in July."

Still, the some investors' continued skittishness is reflected in a few recent sharply down days. On Sept. 10, when tech investors were disappointed that Texas Instruments (TXN) didn't have better sales news to offer, the Nasdaq fell 50 points, or 2.65%. The next day, though, stocks rallied. A decrease in payrolls sparked a downdraft in stocks on Sept. 5, a Friday, but it didn't carry over to the following Monday, when the Dow rose 82 points, and the Nasdaq reached a 17 month high of 1,032. Larry Wachtel, a market analyst at Wachovia Securities, wrote in his closing commentary that day, "The take-away: Don't mess with the bull!"

Here are a few caveats to keep in mind. Sharply rising interest rates could give investors the reason to sell they've been looking for. "We've told our investors to keep their eyes glued to the 10-year note," says SunGard's Jones. On Sept. 11, the yield on that Treasury was 4.32%, down from 4.51% a week ago. Still, the fear persists that rising rates could hurt stocks. "People are aggressive," he says, "but they're prepared to turn defensive quickly if they see things start to deteriorate."

GATHERING MOMENTUM. And the rosy picture driving up stocks now could fade next year. Gross domestic product should grow at a 4% or 5% annual rate in the second half of 2003. But the economy is benefiting from both monetary stimulus and tax relief, which will start to peter out in early 2004. That could mean weaker profits, fewer jobs, and a downdraft in consumer confidence.

Mid-2004 still seems a long time away. So, for now, the stock market is likely to continue climbing its wall of worry. It would take really bad news to stop the increasingly positive momentum, and at least for the near term, there's little sign of it on the horizon. Stone is a senior writer at BusinessWeek Online and covers the markets as a Street Wise columnist and mutual funds in her Mutual Funds Maven column


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