WSJ -- With the Bull Market Stalled, Pros Hunt for Signs of a Peak.
March 9, 2004
With the Bull Market Stalled, Pros Hunt for Signs of a Peak
While Most Don't Think Run Is Over, Many Feel Big Gains May Be Behind
Hints From the Hockey Dads
By E.S. BROWNING
Staff Reporter of THE WALL STREET JOURNAL
To figure out whether stocks are about to fall or to keep rising, Brian Pears, a stock trader in Cleveland, watches several variables -- including one he calls the Garage Indicator. It looks at how much financial television local mechanics are watching. Too much, and stocks are ripe for a fall.
Brian Belski, a market analyst in Minneapolis, tracks earnings, interest rates and the amount of speculative froth he senses when other hockey dads sidle over to ask stock questions during his son's games. Peter Bernstein, a financial historian and investment consultant, focuses on the dollar, inflation and the risk of a terrorist attack.
With stocks in the midst of a bullish run, a number of seasoned investors have started to study their favorite tea leaves, searching for hints of a possible retreat. After bottoming out 17 months ago, stocks recently have soared to their highest levels in two years or more. The Dow Jones Industrial Average has risen 45% since October 2002, while the Nasdaq Composite Index is up 80%. A good number of stocks have hit record highs.
And yet, with most major indicators still well short of their records, they seem to be hitting headwinds. The Nasdaq composite has fallen for six of the past seven weeks. It is 6.7% off its January peak of 2153.83, far from its four-year-old record of 5048.62. The Dow industrials finished Monday at 10529.48, down 1.9% from their recent high of 10737.70 and short of the record 11722.98 they hit in early 2000.
Is this the beginning of the end, or just a bump in the road? The tea-leaf readers' general consensus: The market hasn't gone as high as it can go -- but the majority of the gains are behind us.
Few market analysts, even those who see trouble down the road, say that a severe stock decline is imminent. Many say that the bull market has at least a few more months to run; some say a year or more. The economy keeps getting stronger. Corporate earnings are improving faster than most people expected. Interest rates are at or near 45-year lows, and inflation isn't an issue. Investors are recovering their confidence: They plowed more money into stock mutual funds in January than they had in four years, and preliminary estimates show that the inflows continue. The world seems less frightening than it did a year ago, when the Iraq war loomed.
The problem, as Mr. Bernstein puts it, is that "nothing good lasts forever." As investors take increasing risks in a belief that nothing will go wrong, they become more demanding. And as their expectations rise, the list of things that could go wrong gets longer. The higher stocks go, the bigger the danger of a decline, and the more time the analysts spend combing data for any sign of trouble.
Here are some of the indicators investing pros are watching to get a better handle on the future direction of stocks:
Investor Psychology
How to tell whether the market is properly exuberant -- but not, as Federal Reserve Chairman Alan Greenspan famously put it, irrationally so? Check the local garages and coffee shops, suggests Mr. Pears, the head stock trader at Victory Capital Management, the money-management arm of KeyCorp in Cleveland.
His thinking: If auto mechanics cast an occasional eye toward the financial news, that is good for the market; it suggests an interest in stocks. But if they become so fixated that they put off repairs to watch CNBC, that would be excessive. Right now, Mr. Pears says, interest in stocks "is awakening again, even here in the sleepy Midwest," but it isn't excessive. "When the Starbucks in our building starts putting in a TV so people can watch CNBC, I will get worried."
The Minneapolis hockey-dad reading is similar. "It is kind of bridled optimism," says Mr. Belski, fundamental market strategist at brokerage firm Piper Jaffray & Co. in Minneapolis.
Others say they are starting to see signs of excess. Some clients now want to make riskier investments than are appropriate for them, says Peter Wall, chief investment officer at Chase Personal Financial Services, a brokerage and money-management arm of J.P. Morgan Chase in New York. "We have those conversations quite a bit. It is a challenge to try to manage those expectations," he says.
Francois Trahan, chief investment strategist at New York brokerage firm Bear Stearns, follows five indicators of investor psychology. Those range from demand for put options -- which can protect nervous investors by giving them the right to sell stocks at a prearranged price -- to the number of stocks hitting new lows and highs. He thinks the indicators signal that investor optimism is getting stretched and a pullback is ahead.
"I would say that the best of times are behind us," Mr. Trahan says.
Paul Desmond, president of research firm Lowry's Reports in North Palm Beach, Fla., tracks similar barometers, and he has concluded that serious problems still are months away. He expects stocks to turn down about nine to 12 months after a peak in the number of stocks hitting new 52-week highs. The number of new highs peaked in December, he says, suggesting that the rally has some months to run.
Other gauges, such as the number of stocks rising compared with the number falling, suggest that the rally still is fairly broad and resilient, he says. But Mr. Desmond, too, is seeing signs of excess. People with little investing background are asking to subscribe to his research service; he generally sends them elsewhere. And he says he is seeing an uptick in interest in gambling, such as television shows about poker and Las Vegas.
His conclusion: Stocks can continue to rise for some time, even after investors go a little off the deep end. "It is entirely possible in my mind that we could be headed back into a period of extreme speculation even greater than we saw in 2000," he says. It would be unhealthy, but it also could last for a while, he says.
Interest Rates
"The biggest concern we have right now is the risk of a resurgence in inflation," producing higher interest rates and choking off market gains, says Mr. Wall at Chase Personal Financial Services.
This certainly isn't a problem today. The most closely watched market interest rate, the yield of the 10-year Treasury note, has fallen since early September, to 3.8% from 4.6%. Consumer-price inflation has been running at about 1.9%.
But some professional investors worry because they believe that low interest rates have been the single biggest factor underpinning the stock market. Low interest rates help the economy by reducing borrowing costs for consumers and companies. That helps corporate earnings. Low rates also make investments such as bonds, certificates of deposit and money-market accounts much less attractive than stocks.
Sooner or later, most investors and analysts realize, rates will have to rise again to prevent inflation. In the past, such as in 2000, rising rates have been a chief catalyst for market declines.
The low-rate policy of Mr. Greenspan, together with the government's deficit spending, mean that the Fed chairman "is watering and fertilizing inflation down the pike," worries Jon Brorson, head of growth-stock investing at money-management firm Neuberger Berman. He fears that inflation could start to be a problem within the next year.
So far, the Fed is calling itself "patient" on rates and there isn't any sign of higher Treasury yields. Mr. Brorson and Mr. Wall both remain bullish on stocks for now. But they are watching for signs of higher rates -- in the form of higher Treasury yields -- which they say could signal the need to pull back from stocks. "I am still looking at Mr. Bond to give off signals," says Mr. Brorson.
Earnings
Mr. Wall is also watching for what the pros call "earnings disappointments," or quarterly corporate earnings reports that fall short of expectations.
"Our feeling is that some of the first signals of trouble for stocks will be some earnings disappointments," which could come as soon as July, when second-quarter earnings news begins to be announced, says Mr. Wall. Many companies already reported strong earnings gains last year, which will make it harder to show big percentage gains this year. And as the year goes on, companies will be hiring more workers, making it harder to keep showing strong productivity gains.
The problem, adds U.S. investment strategist Richard Bernstein at Merrill Lynch, is that analyst expectations for corporate performance are rising, just as they did when stocks went to excessive levels in the late 1990s. Mr. Bernstein, who has been warning for months that stocks are too high, says his data show that analysts are forecasting 2005 profit margins for some technology companies that exceed the margins seen during the stock bubble.
Earnings disappointments at the end of 1999 and the start of 2000 helped end that bull market. At least initially, the problem wasn't that earnings fell; it was that analysts had come to expect such dramatic earnings gains that even double-digit improvements weren't enough to keep stocks aloft.
But most analysts don't believe expectations for most stocks have risen to such an extreme level. "I think earnings are understated still, and I think there is more upside than downside from earnings," says Mr. Belski at Piper Jaffray.
The market will get an initial indication of earnings performance this month, when companies expecting disappointments begin to warn of problems to come in first-quarter earnings.
Money Flows
Some analysts believe that stock movements, like those of any economic system, are simply a matter of supply and demand. To forecast the market, they track what they call "money flows" -- supply and demand for stocks.
One cloud on the horizon is that more companies have begun issuing new shares, or making initial public offerings, to take advantage of the rising demand. And more corporate insiders have begun to sell their stock, to realize gains. All of that pushes supply higher, and analysts such as Phil Roth, chief technical market analyst at New York brokerage firm Miller Tabak + Co., say the rising supply has been a factor in holding down stock gains.
Researcher and money-manager Laszlo Birinyi of Birinyi Associates in Westport, Conn., analyzes supply and demand for individual stocks, checking to see whether investors are buying or selling at certain key points. "If stocks start hitting new highs and people are selling into those highs, that to me is the best signal of all" of trouble to come, Mr. Birinyi says. It means that money is beginning to move away from those high-priced stocks, not toward them.
He also looks at how people react to good news -- do they sell and take their profits, or do they buy more?
"Right now, people are reacting pretty strongly to good news and reasonably well to mediocre news," meaning that demand is keeping pace with supply, Mr. Birinyi says. And investors generally have been buying stocks when they rise, not selling, indicating continuing support for the market.
Some analysts track a different kind of money flow: the amount of cash going into mutual funds. In January, investors channeled almost $44 billion in net new money into stock mutual funds, the highest monthly figure since the bubble burst in 2000. That helped pushed overall mutual-fund assets -- including bond and money-market funds -- to $7.54 trillion, a record, surpassing the previous high hit in the summer of 2000, shortly after the bubble burst. Most analysts view this as a sign of confidence rather than excess.
Politics
With the presidential election looming, and the nation still nervous about the terrorist threat, politics is playing a bigger role in the market than normal.
Investors have become fascinated with what they call the "presidential cycle," a historical pattern in which stocks tend to do better in the two years before a presidential election, and worse in the two years after. The reason, apparently, is that politicians find ways to pump up the economy before an election.
Fears have spread that, if the cycle holds true, stocks could weaken by the end of this year. On top of that come worries about the election's outcome. Although historical studies suggest that stocks do better under free-spending Democrats than under tight-fisted Republicans, some investors worry at the prospect of a Democratic victory. President Bush has opened the public purse in an effort to strengthen the economy, and cut taxes in ways that have helped investors.
"If more and more people get concerned that Bush could be defeated, after it appeared a few months ago that he couldn't be challenged, people might get worried about a repeal of all the tax incentives he put in place that were very bullish for the market," says Henry Herrmann, chief investment officer at mutual-fund group Waddell & Reed in Overland Park, Kan.
Economic Trends
Many investors currently are focused on employment, believing that when new job creation strengthens, consumers will spend more, sustaining corporate earnings and stock values. But in a display of Wall Street's upside-down logic, some analysts take the opposite view: They consider strong employment numbers to be bad for stocks.
When employment improves, worries Mr. Wall at Chase Personal Financial Services, the Fed will take it as a sign that it can raise interest rates. Hiring will push up corporate costs and make productivity gains harder, which in turn could hurt profitability. Prosperity for ordinary people, in other words, could be bad for stocks, because it will raise fears of inflation, higher rates and slower profit growth. "It sounds a little bizarre, but that would be a sign that we are going to have problems down the road" in the stock market, Mr. Wall says.
Another worry is the dollar. A sudden dollar selloff, which market participants don't widely expect now, could shock the stock and bond markets, since it could provoke foreign investors into pulling back from dollar-denominated securities. "If the dollar reaches a critical stage it could trigger a lot of awful things. I think about the dollar a lot," says Mr. Bernstein, the market historian.
Write to E.S. Browning at jim.browning@wsj.com
Updated March 9, 2004
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