Investors are betting the subprime mess and bond jitters won't hurt equities. But will they get burned later?
It's the whiplash market.
Two days after fears about the subprime housing market and turbulence in the bond market spooked investors, bullish sentiment roared back on July 12, pushing the Dow and Standard & Poor's 500 indexes to new records. The Dow Jones industrial average's 283-point, 2.1%, jump was its largest in more than four years.
The S&P 500 gained 28.94 points, or 1.91%, to 1547.70, and the tech-heavy NASDAQ composite index rose 49.94 points, or 1.88%, to 2701.73, a six-and-a-half year high.
Consumer Activity Spurs Investor Activity
The buying spree commenced after several major retailers, including Wal-Mart Stores, Target, and Abercrombie & Fitch (ANF), released June sales figures suggesting that stalwart U.S. consumers were back to their old spending ways and that corporate earnings would rebound. "Maybe the consumer isn't dead after all," says John Wilson, chief technical strategist at Morgan Keegan.
A $38 billion mega-deal in the mining sector put the spotlight back on mergers-and-acquisitions activity, as Rio Tinto (RTP) agreed to acquire Canada's Alcan (AL). The bulls' primary driver has been "vast and beyond belief" levels of M&A, buyout, and stock buyback activity, says Rob Brown, chief investment officer of Genworth Financial Asset Management (GNW) in Encino, Calif.
At the same time, consumer spending is strong and both earnings and the economy seem to be growing. "People are in the process of revising their expectations upward across the bases," Brown says.
But hasn't it been a season of fear for investors? What about the subprime-backed bond mess and the downward revision of billions in asset values by rating agencies? What about the retrenchment in newly cautious debt markets and the likely slowing of M&A activity?
Yes, those issues still hang over Wall Street, and the retail, M&A, and trade deficit picture that emerged July 12 did nothing to alter them. "I don't think anything has fundamentally changed from last week," says Barry Ritholtz of Ritholtz Research & Analytics.
Eleven years ago, a fellow named Alan Greenspan famously introduced the phrase "irrational exuberance" into the public consciousness. The Dow's 1.1% drop on July 10 may have been irrational, just as the exuberant surge two days later could be called the same. "Sometimes you get a day when there are more buyers than sellers," says Ritholtz, casting for an explanation. "The market is imperfectly inefficient."
Sam Stovall, chief investment strategist at Standard & Poor's, says the subprime threat "had been talked to death" in the past few days, priming the market for a new catalyst to take it higher. (S&P, like BusinessWeek, is a unit of the McGraw-Hill Companies (MHP).)
Investors' spirits were stirred by good news on chain store sales from retailers including Wal-Mart (WMT; +2.41%), Target (TGT; +6.77%), and J.C. Penney (JCP; +6.04%). Macy's (M) did not share in the good news, after its sales were weaker than expected and the company joined Home Depot (HD) and Sears Holdings (SHLD) in cutting its earnings outlook. Macy's was off nearly 3%, to 39.25.
Is the bullish pace sustainable or is a nasty tumble in store? Stovall says there has been an unusually high level of caution and skepticism in the market lately. "We could end up seeing a lot of these bears who are on the sidelines throw in the towel," he says, leading to further rallies. At the same time, broad-based gains in recent months have regularly prompted investors to cash out some positions and clear money from the game.
Briefing.com, a Chicago market analysis firm, noted that June may not be the best indicator of the retail sector, given heavy merchandise promotions. "July will be a more telling month with respect to same-store sales activity and the consumer's willingness to spend in a presumably less promotional environment," the firm said.
Trouble on the Horizon?
More aggravating factors in the subprime situation, or another factor, could derail the rally. Subprime problems remain an "indirect threat" to the market because of the danger they pose to debt markets and M&A and buyback activity, Ritholtz says.
Many seem to believe problems with housing and subprime mortgages are confined to one corner of the economy. The selling earlier in the week, blamed largely on the concern over subprime, may have been simply "a knee-jerk nervous reaction as we start the earnings season," says Wilson of Morgan Keegan.
One other factor possibly cheering equity players? Continued weakness in the U.S. dollar vs. the euro. Roger Volz, chief technical strategist for Swiss American Securities, thinks the lower greenback will actually help the bottom lines of multinational corporations, and he believes that's one reason the Dow has surged to record heights, according to S&P MarketScope. Big multinationals like American Express (AXP; +5.06%), Caterpillar (CAT; +2.34%), Exxon Mobil (XOM; +2.67%), Honeywell (HON; +2.89%), Merck (MRK; +3.82%), and 3M (MMM; +2.33%) were among the blue-chip leaders.