Wall Street's Fake Rally?
The stock market surge comes with a catch: It may be too good to last.
FORTUNE
Monday, April 1, 2002
By David Stires
This market needs a warning LabeL:"Danger! Excessive exposure causes investor whiplash!" Take the first week of March. The Dow stormed ahead with astounding back-to-back 200-point gains--the biggest two-day jump since December 2000. But the next day the market dove more than 100 points, and it has continued to swing wildly ever since. Overall the Dow may have rebounded more than 30% from its September low (technically a bull market), but the intervening months have seen hefty dips and intense volatility. So is the run-up for real, or are we simply heading for a trading range?
If history is any guide, the answer is the latter. Consider this: Back in 1975 the conditions were almost identical to the head-fake rally we're seeing now. There was a relentless stream of dour news: a war overseas, a major scandal at home, and two years of falling stock prices. Then suddenly the Dow surged 40% in just six months. People raced back into Nifty Fifty stocks like Avon and Polaroid, only to get slammed as oil prices, inflation, and interest rates spiraled upward. The Dow went on to trade sideways for seven long years before finally breaking out in a prolonged bull market in 1982. Says Heartland Value fund manager Bill Nasgovitz, who became a value-investing devotee after the bear market three decades ago:"After all this time, we're back in the '70s."
Sound depressing? It is. Admittedly, the economy is far healthier than it was in the '70s--not only is inflation under control, but interest rates are low too. For markets to ignite, however, interest rates generally need to be falling (when rates fall, bonds become less attractive, and investors are willing to pay more for a company's future earnings). After 11 rate cuts last year, the Fed can't go much lower. In fact, following the raft of positive economic news in February, many believe Fed chairman Alan Greenspan could raise rates as early as May."The biggest threat to this market is rising interest rates," says Jeremy Siegel, professor of finance at the Wharton School.
Worse, stocks are still shockingly expensive. Despite consecutive down years, the Dow is currently only 10% off its all-time high. Using a formula based on a combination of both historical and projected profits, the Leuthold Group calculates that the S&P 500 trades for a lofty 24 times earnings; the index would have to fall 29% to return to its median P/E multiple since 1957, which is 17. According to Ned Davis Research, no bull market in history has started with P/Es this high.
Then there's the problem of post-traumatic stock market disorder. Back in the '70s, investors took a long time to recover from the bubble's bursting."People had been irrationally exuberant and then got slammed so badly," recalls Charles Hill, who was a technology analyst at the time and is now director of research at First Call/Thomson Financial. That time around, the continuing oil crisis caused inflation to soar into the double-digit range, prompting the Federal Reserve to jack up interest rates. With yields as high as 20%, money-market mutual funds--not stocks--were the hot investments. It was only after the Fed started cutting rates that the long bull market began in 1982.
So what could save us from seven years of dead money? There is a slim chance companies could beat profit forecasts. However, with analysts predicting a tech earnings rebound of 137% in the third quarter and 74% in the fourth, Hill remains skeptical that companies can even meet those numbers. What's more likely to happen, as Ned Davis' Tim Hayes suggests, is that the Dow and S&P 500 trade in ranges great enough to earn bull and bear market definitions, but remain flat in the longer term. That would give investors opportunities to make money during rallies, while good stock pickers, of course, could still prosper. Nasgovitz, for example, sees a '70s-style"stealth rally" in small-cap and value stocks continuing. So returning to the 1970s may not be so bad after all--as long as there's no tie-dye involved.
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