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Stocks: Does Anyone Else Hear Snorting?


The Netscape IPO and Windows 95 aren't coming back. But a growing number of investment strategists think stocks might be on the verge of 1995-like returns -- if new Federal Reserve Chairman Ben S. Bernanke plays things right.

A few months ago it looked as though Bernanke would have a monster of a job on his hands. Core inflation figures were jumping, housing was showing signs of froth, and gross domestic product was growing at a strong 4% clip. The Fed would have to raise interest rates long into 2006, the thinking went, to slow the economy, pop the housing bubble, and establish Bernanke's bona fides as an inflation fighter. It wasn't a good scenario for stocks, which usually perform poorly when rates are rising.

Things may be changing. The long campaign of rate hikes, which sent the federal funds rate from 1% in June, 2004, to 4.5% now, seems to be working: Housing began to cool in the fourth quarter, while core inflation slowed. In fact, the rate hikes might be working a little too well, judging from the weak fourth-quarter gross domestic product reading of 1.1% and some corporate earnings misses.

Bernanke's path, say bulls, looks clearer now. Many economists expect the Fed to stop raising rates soon, perhaps after one or two more quarter-point hikes.

That could set up the soft landing Edward E. Yardeni, chief investment strategist of Oak Associates Ltd., has been waiting for. In late 2004, Yardeni began making the case that the second half of the decade would mirror the second half of the 1990s. The parallels between the first halves of both decades, he said, are unmistakable: a recession, a slow recovery, a divisive election (1994 and 2004), and interest rate hikes that cooled stocks. Once an economic soft landing takes place and the hikes end, he posited, stocks will rise, just as they did in 1995.

Market watchers thought Yardeni was crazy. The tech boom is over, they scoffed, and geopolitics and energy prices are now a constant drag on investor confidence. Plus, long-term interest rates fell precipitously in the '90s, an unlikely scenario now.

But a few big-picture types are coming around to the view that 2006 will see the next leg up in the stock market. Joseph McAlinden, chief investment officer of Morgan Stanley Investment Management's (MWD) global equity group, says stocks are set to surge, albeit with some volatility. "Stocks will be the best-performing asset class," he says. Neal M. Soss, chief economist for Credit Suisse First Boston LLC (CSR), agrees. "A flow-of-funds argument says money has to go somewhere." His bets: stocks and commercial real estate.

History is on the bulls' side. The Fed has waged five tightening campaigns since 1983. In four of them, the market gained an average 15.5% in the following 12 months. The exception was May, 2000. But stocks were wildly overvalued then, note the bulls, with a forward price-earnings ratio for the Standard & Poor's 500-stock index of 24, vs. the historical average of low double digits and today's 15.

CASH TO BURN

The optimists also point to corporate coffers. Despite a few high-profile fourth-quarter earnings misses, fourth-quarter operating earnings for the S&P 500 are set to post a 12.6% year-over-year gain, the 15th consecutive quarter of double-digit growth, a record. The extended run has given companies record cash to fuel acquisitions, capital spending, dividends, and share buybacks. Those activities should protect their stocks when earnings growth decelerates to the historical range of 8% to 10%, say the bulls.

Thomas McManus of Banc of America Securities (BAC) LLC published a research report on Feb. 1 picking apart the 1995-2006 argument point by point. Others note that a strong first-quarter GDP report could force Bernanke to keep his foot on the brake longer than the bulls think (page 27). Richard Bernstein, chief U.S. strategist at Merrill Lynch & Co. (MER), says Bernanke may well go too far: "The Fed has never known when to stop tightening."

One thing is clear: Stocks, stuck in a narrow range since late 2003, are due for a move up or down. What they need, says Brian Gendreau, a strategist at ING Investment Management, is a catalyst -- like, say, the end of rate hikes.

By Mara Der Hovanesian


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