The Usual Suspects Are Absent
As Stock Market Takes a Hit
By GREG IP
Staff Reporter of THE WALL STREET JOURNAL
The stock market broke a lot of history's rules on its way up in the past
four years. It appears to be doing the same on its way down.
The correction now under way is not
happening with the usual culprits that trigger
bear markets. Inflation is docile. Long-term
interest rates are tumbling. The economy, so
far, is not in a recession.
The plunge is being driven by a chain of toppling foreign economies. And
while few analysts can quantify their impact on U.S. corporate profits or
economic growth, the events are chipping away at some of the most
cherished assumptions that have underpinned the long bull market.
That doesn't mean the correction will turn into a bear market. (Corrections
are usually defined as a 10% drop from the highs; the Dow Jones
Industrial Average is now down 12.6% from its July 17 high. A bear
market is typically considered a 20% or greater drop.) But it suggests that
the risk is rising. Even some stock-market bulls are prefacing their views
with a lot of ifs: The bull market is intact if China doesn't devalue, if the
Federal Reserve cuts rates.
There is, perhaps, a more benign interpretation of the unusual events
hammering stocks right now. Overseas events have acted mostly to
increase investor uncertainty and damage their confidence. By and large,
they have not drastically changed the fundamentals of overall profit growth
(though that could yet happen) and low interest rates. All of this means that
if stocks were overvalued a month ago, they're a lot less so now. That,
however, is small comfort, given that negative sentiment can drive stock
prices down far more than the fundamentals would suggest, just as in good
times positive sentiment can drive them higher than the fundamentals merit.
And right now, psychology is very negative.
Recent Corrections
Largest pullbacks/corrections in major market indexes, 1995-1998
DATE OF PEAK
DATE OF LOW
% CHANGE
DJIA
Aug. 6, 1997
Oct. 27, 1997
-13.3%
July 17, 1998
Aug. 27, 1998
-12.6
March 11, 1997
April 11, 1997
- 9.8
May 22, 1996
July 23, 1996
- 7.5
S&P 500
July 17, 1998
Aug. 27, 1998
-12.1
Feb. 18, 1997
April 11, 1997
- 9.6
Aug. 6, 1997
Oct. 27, 1997
- 8.7
May 24, 1996
July 24, 1996
- 7.6
Nasdaq Composite
June 5, 1996
July 24, 1996
-16.6
July 20, 1998
Aug. 27, 1998
-16.3
Oct. 9, 1997
Dec. 24, 1997
-14.1
Jan. 22, 1997
April 2, 1997
-13.5
Source: WSJ research
Russia accounts for less than 1% of U.S. exports. But part of the bullish
thesis behind the long upward rise in stocks is that as more and more parts
of the world were entering the market-driven capitalist system, it offered
vast new opportunities for economic growth and sales for U.S. companies.
The events in Russia in recent days have severely tested that assumption.
"The extreme risk here is that for all intents and purposes, Russia is in the
process of exiting global capitalism," says Jeffrey Applegate, the bullish
investment strategist at Lehman Brothers. "Let's keep this in perspective.
Russia's gross domestic product is equal to about 4% of U.S. GDP. But
they're the second-biggest nuclear power, and that's another degree of
risk."
One country's implosion wouldn't be so bad, except that it's not just one.
The financial crisis started a year ago with Thailand, spread to the rest of
the Asia, then Russia, and is now threatening Latin America. Thursday, the
central bank of Canada, the U.S.'s largest trading partner, jacked interest
rates up a full percentage point in an unsuccessful attempt to stem the fall in
the Canadian dollar, a victim of plummeting commodity prices.
Through this foreign turmoil, the U.S. economy has continued to sail
steadily, underpinned by buoyant domestic consumption. But eventually, if
enough of its trading partners catch Asian-like problems, the U.S.
economy is bound to feel it, too. There is also the risk that as stock prices
fall, consumers will respond to the loss of wealth by spending less,
endangering the domestic economy.
That the catalysts of the correction are primarily overseas only amplify the
psychological nature of the selling. U.S. investors are trading on
secondhand information, says John Manley, stock strategist at Salomon
Smith Barney. "So they go to bed at 9 o'clock at night and wake up at 5 in
the morning and their day has been made for them. A couple of weeks of
that, there's a tendency to get on the sidelines and say 'to hell with it.' "
But behind the uncertainty and terrible headlines, it's still difficult to prove
that the fundamental underpinnings of the market are dissolving.
"U.S. stocks have overreacted to the incremental information," says Abby
Joseph Cohen, Goldman Sachs's bullish strategist. "What are the
economic ramifications of what's going on? I can cite all kinds of numbers
that sound calming: we do 0.8% of our foreign trade with Russia. We've
talked to many of the banks we follow, and they say they're fully reserved
for exposure to the nations attracting attention. So it doesn't sound like the
economic impact on the U.S. will be very pronounced.
"But the first part of the contagion is, 'Omigosh, maybe I need to
re-examine my assumptions.' " She judges stocks to be undervalued and is
sticking by her year-end target of 9300 on the Dow industrials.
Adds Mr. Applegate, "Roughly ... 85% of U.S. profits come from the
U.S. and Europe. Unless you can make a case that you have significant
problems in those regions, it's tough to make a case you have a global
recession and global bear market."
Furthermore, there is key support for stocks in the fact that 30-year bond
yields have fallen to their lowest levels since the 1960s.
"A classic bear market in the U.S. is always driven by Fed tightening,
rising interest rates and a sharp correction in the bond market," says
Stephen Roach, chief economist at Morgan Stanley Dean Witter. "If we
get a bear market because of the Asian currency crisis, this is unusual, this
is as atypical as it's ever been. The odds of that have certainly increased:
This is an unprecedented global currency crisis."
Both those fundamental positives -- continued, if softer, profit growth and
falling interest rates -- carry huge caveats. One is that profit expectations
have been falling all year and are likely to fall further, especially with
"preannouncement" season fast approaching.
There is also a growing minority view that the current business cycle differs
fundamentally from others in the postwar period. The collapse in foreign
markets and commodity prices means an inability to raise prices has
become a major threat to corporate profits. That is good for bonds, bad
for stocks, and thus the fall in bond yields is not helping much.
For the first time in postwar history, selling prices are declining year over
year for the corporate sector as a whole in the middle of an economic
boom, says Warren Smith, managing editor of Bank Credit Analyst
ForeTrends, a Montreal financial forecast journal. He thinks stocks will
eventually fall 20% to 25% from their highs.
"This is unusual in the postwar period but it's not unprecedented in
history," says Jeremy Siegel, a professor of finance at the University of
Pennsylvania's Wharton School of Business. The last deflationary bear
market, in which "stock prices continue to plunge with interest rates, was
the 1930s. That's a condition that didn't exist in the 1960s and 1970s
when inflation and higher interest rates were the biggest sources of the
bear market."
Prof. Siegel isn't predicting a rerun of the 1930s plunge, but he is
pessimistic for the short term: "It's very hard for the market to mount
another increase until the earnings picture clarifies and the resumption of
strong earnings can take place. That may take quite a while." But he adds,
"For long-term investors, I still think stocks offer good value and in fact
better value than two months ago."
In the short term, at least, there might be a benefit in the extreme
pessimism taking over the markets. Contrarian theory holds that markets
can only recover at the point of maximum pessimism when there's no more
selling left. The bullish percentage of investment advisers surveyed by
Investors Intelligence this week has fallen to 40% from 54% five weeks
ago, while the bearish percentage has risen to 39% from 23% (the balance
expect a correction).
interactive.wsj.com
Regards, Jeff |
