Predicting a Big Market Sell-Off: A Crazy Exercise
By Pierre Belec
Reuters
NEW YORK - The market is incredibly overpriced and Federal Reserve Chairman Alan Greenspan stands ready to knock the legs out from under the longest-running bull market.
But Wall Street bulls say stocks are not in a crash mode.
''Stay bullish, if you can take the risk,'' the experts say.
The economy is still in great shape and with corporate profits expected to be up more than 20 percent in the second half of this year, the stock market should be able to extend its winning streak -- even if the Fed raises interest rates a notch or two, the bulls say.
And, they view the guesswork on when the ''Big One'' will finally send the market crashing in flames as just a crazy exercise that's failed to hit the bull's eye for nearly five years.
Only recessions and financial crisis have been known to cause tremendous stock market upheaval. So far, there is no evidence that either will slam stocks.
Greenspan, who has been trying to talk down the market since December 1996, when the Dow Jones industrial average was nearly half today's level, sees stocks as one of the greatest manias ever.
The Federal Reserve's own market valuation model says stocks are overvalued by an eye-popping 40 percent.
The model, which compares corporate earnings with the 10-year note yield, reached a record 48 percent in July, when the Dow and other indexes zoomed to new record ground. The model has come down from its peak due to the market's recent pullback and a jump in bond interest rates to almost two-year highs.
Despite the bearish signals, the Dow index is still up an impressive 17 percent for the year while the Standard & Poor's 500 index has gained nearly 7 percent and the Nasdaq Composite index is up 17 percent.
Greg Smith, chief investment strategist for Prudential Securities, says the Street should not lose sleep over the Fed's market model. The trouble with the Fed's stock gauge is that it may be oversimplifying the market's valuation.
''I strongly suspect that, historically, the largest and probably the best companies in America have been awarded premium valuations when the economy climate has been very difficult,'' he said.
During the global financial crisis that rocked markets worldwide in 1998 as Asia slid into recession, investors ran to the relative safety of U.S. companies with the biggest capitalizations, the smartest managements, greatest market positions and predictable earnings. The goal was to ride out the tough economic times.
Asia, Latin America and Russia are now back on their feet. Analysts are predicting solid gains in almost all Asian markets next year as investors flow back into the region.
'''Very difficult' certainly would describe the climate in 1998,'' Smith said.
''But in the current stock market's climate, a mere 50 stocks represent well over half of the S&P 500's entire capitalization,'' Smith said. ''So those 50 stocks' valuations have a very heavy influence on the valuation of the overall market.''
Smith is telling his clients to stay bullish with an asset allocation of 75 percent stocks, 10 percent bonds; 5 percent real estate, and 10 percent cash.
''If the market makes it through August, we feel it will be poised for a rally and that it might be a pretty good one,'' he said.
What about the threat that the Fed may unleash a series of interest-rate increases after raising the fed funds rate by a quarter percentage point in June in a preemptive move against inflation?
Interest-rate increases, which the Fed uses to keep the economy from generating too much inflation, can be deadly for stocks, and they have been known to stop raging bull markets in their tracks.
But the experts say the stock market seems to be overly obsessed about inflation and the fears have been overblown.
Sure, commodity prices are rising again, but investors need to realize that commodity markets are just simply recovering from the deeply oversold conditions of two years ago, when nearly half of the world was on the verge of collapse.
''What we're fighting, in some ways, is the unsustainably low numbers that were experienced over the last couple of years as the world financial crisis pushed prices down below anything that would be healthy or sustainable,'' said Smith.
Meanwhile, the interest-rate watch continues. In June, the Fed telegraphed plans to raise the cost of borrowing, but investors are now less certain about the central bank's next move at the Aug. 24 meetings of its policy-setting group.
The uncertainty has sparked a rise in bond interest rates and boosted the costs of such things as mortgages and personal loans.
Home mortgage rates, which have risen to 8 percent, are expected to slow home sales and drive first-time buyers out of the market.
Critics say inflation is not a problem.
The Fed is worried that wage-led inflation could be a threat to the economy after the Employment Cost Index in the second quarter rose 1.1 percent -- the biggest leap since 1991 -- amid the tightest labor market in decades.
But the jury is still out on whether workers' wages are starting to explode. The second-quarter rise came on the heels of small increases in the earlier two quarters.
A closer look at the second quarter's labor cost numbers also shows that the biggest factor in lifting the index was a jump of 3 percent in the volatile sector of the ECI for finance, insurance and real estate after a drop of 0.73 percent in the first quarter.
Another reason to believe that inflation is not a problem is that with productivity gains of 2 percent per year, U.S. companies will be rich enough to cough up wage increases of 4 percent while keeping the price of their goods stable.
The bulls say the earnings story also looks good, at least, through the next half-year.
The Index of Leading Economic Indicators, which gives a window on the economy for the next six to 12 months, rose 0.3 percent in June after a 0.3 percent gain in May. The index has racked up an impressive string of eight gains in nine months, extending the economy's expansion that began in March 1991.
Some experts say it's almost a sure thing the Fed will move rates up later this month.
''The 25-basis-point rise in June was not expected to make much of a difference to slow the economy, and for that reason, people should expect further action by the Federal Reserve,'' said Allen Sinai, chief global economist and a Fed watcher at Primark Decision Economics Inc.
He said the Fed would need to raise rates between 50 basis points to as much as one full point in a 12-month period to have a significant impact on the economy's growth.
So, why don't investors see some risk in owning stocks?
Don Hays, chief investment officer for Wheat First Union in Richmond, Va., said Wall Street still needs to be convinced the Fed is not kidding about jacking up the cost of borrowing money so as to slow the economy's growth.
''Typically, it takes three rate increases to do the job, which has led to the old Wall Street rule, 'Three steps and a tumble,''' he said.
This would mean that stocks will get hit by three consecutive rate increases before heading sharply lower.
Why does it take three interest-rate moves to jar the market?
''When the bull market momentum builds up, people become so positive, it's hard to kill their enthusiasm,'' he said. ''Investors get the feeling that nothing can hurt them and the market is unstoppable.''
An overly positive market mentality may now be the thing that is supporting the market.
''Investors view any market pullback as a buying opportunity, even after the Fed has raised rates,'' Hays said. ''Now, they are waiting for the second Fed move, which will probably cause a little selling reaction before it comes back up again.''
The third rate increase may send a loud wake-up call for Wall Street and there will be some ''serious selling,'' he said. |
