Hows this for a little awareness! Threats to the bull, from Iraq to the year-2000 problem
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BY JAMES M. PETHOKOUKIS
Talk about resilience. Even the threat of Armageddon couldn't bring America's powerful bull market to its knees. Last week, the Dow Jones industrial average finished taking back last fall's 13 percent drop, soaring to a record 8370.10 despite turmoil in Asia, a sex scandal in the White House, and recent apocalyptic pronouncements from Boris Yeltsin that a U.S. attack against Iraq could ignite a world war. Clearly, investors aren't taking Yeltsin too seriously--just as they haven't taken the prospect of instability in Clinton's presidency seriously either.
Such widespread complacence is certainly understandable. During its more than seven-year bull run, the market's occasional problems have prompted many bargain-hunting investors to buy even more stock. Perhaps they always will. But before embracing the "end of history" approach to investing, we wanted to assess any possible threat that could yet turn 1998 into the bull market's finale.
To that end, U.S. News has identified five potential problem areas--and has rated the seriousness of each one on the U.S. News risk scale. A rating of 1 means look for a buying opportunity. A 5 rating means that hiding your assets under the mattress suddenly looks like the sort of canny investment move Warren Buffett might make.
The Asian crisis (3)
Fears about the troubled region's impact on the U.S. economy led to the stock market's big correction last year. But now a "sigh of relief" about the Pacific Rim has encouraged the market's strong rebound, explains Abby Joseph Cohen, cochairman of the investment policy committee at Goldman, Sachs & Co. To some degree, investors here are taking their cues from strengthening Asian stock markets. South Korea is up 44 percent, Thailand 43 percent, and Hong Kong 27 percent from recent lows. But more important, fourth-quarter-earnings reports hint that the damage to U.S. corporate profits won't be as severe as first thought--even though earnings growth is slowing. With 82 percent of companies in the Standard & Poor's 500-stock index already reporting, 45 percent have topped analysts' expectations, and only 33 percent fell short. Those results are not far off the five-year averages of 51 percent and 35 percent, respectively, notes market analyst Peter Canelo of Morgan Stanley Dean Witter. As he sees it, "Corporate profit growth remains on track and will continue to pleasantly surprise investors." Lessening concern about Asia is also reflected in the bond market, where 30-year yields have drifted higher after falling to a low of 5.73 percent on January 5. Traders had been betting that Asia's troubles would sharply slow U.S. economic growth and further reduce the risk that inflation would pick up--an event that would reduce bonds' rate of return. Investors, however, should still expect Asia's woes to lead to occasional market sell-offs: Some U.S. firms won't feel the full effect of currency declines and slowing regional demand for U.S. exports until the second half of the year. Despite that, Cohen thinks her year-end Dow target of 8700 is easily achievable. And Federal Reserve Chairman Alan Greenspan contributed to the growing optimism about Asia when he told a Senate panel last week that there was only a "small, but not negligible, probability" that the region's turmoil would unexpectedly damage U.S. growth.
Conflict in the gulf (3)
U.S. airstrikes against Iraq--if they happen--might seem like a good opportunity for investors to sell stocks and take profits on their big gains of the past few years. America's last major bear market eight years ago more or less coincided with Iraq's invasion of Kuwait--and America's military response. Two weeks after the Dow hit a record high of 2999.75 on July 17, 1990, Iraqi tanks rolled into Kuwait City. By October 11, the Dow had fallen 21 percent. As it turns out, however, the financial markets really were warning investors about an economic setback--not a military one. In hindsight, the United States was already a month into a nasty recession when the invasion started, notes Christine Callies, investment strategist at Credit Suisse First Boston. Now--as the president's annual economic report to Congress highlighted last week--the American economy is expanding and shows few signs of trouble. Its 3.9 percent growth rate in 1997 was the strongest in nine years, while the 1.7 percent inflation rate was the lowest in 11 years. That's why Callies thinks a military strike would most likely provoke a 10 percent downturn, not a full bear market. Also, analysts don't think the stakes in a U.S.-Iraqi conflict are nearly as high this time. In 1990, the strategic control of oil--the lifeblood of the global economy--appeared to be at great risk. That sense of maximum danger, as Lehman Brothers' Jeffrey Applegate points out, was the reason crude oil futures increased from $15 a barrel in June of that year to over $30 until it became clear in January 1991 that Iraq was going to be little match for U.S.-led coalition forces. In 1998, by contrast, the conflict does not seem to investors to pose a major threat to global oil supplies. So far at least, the struggle over whether Saddam Hussein will allow United Nations teams to conduct weapon inspections has not created a sense among investors that a regional conflict is inevitable. In fact, oil prices have actually edged lower lately--even as U.S. military action seems more likely. Overall, Applegate thinks the stock market's response to another gulf war would be "much more muted" than it was in 1990. But he reminds investors that there is always the chance a limited conflict could spread, a development that would surely unsettle world markets.
The White House scandal (1)
Looking at Wall Street's blas‚ reaction to affairs of state, you might wonder how investors can be so calm about a crisis that could potentially remove a president from office. Simple. Whether Clinton stays or goes, says Thomas Gallagher, political analyst at Lehman Brothers, "the policies that have brought the markets to their current levels aren't at risk."
The president's survival would mean status quo; a Gore administration wouldn't be much different. And although Clinton's departure would probably cause an immediate drop in the market, White House crises have rarely been the cause of extended market declines. James Bianco, director of research for Arbor Research & Trading, has examined 14 instances since World War II where a president's approval rating has fallen 10 percentage points or more in a month and dropped below 50 percent. The Dow has gained an average of 2.7 percent during the next three months. The one big exception: the 1973-74 bear market, when the Dow fell 45 percent as the Watergate drama played out. But the markets were reacting to President Nixon's poor management of the economy more than to his moral lapses. From the start of 1973 to Watergate's climax in August 1974, inflation nearly tripled, oil prices more than quadrupled, and consumer confidence plummeted.
The Federal Reserve (2)
A year ago, with the mere utterance of the words irrational exuberance, Fed Chairman Greenspan could send financial markets reeling. But these days, Greenspan and his fellow Fed governors find themselves "out of the equation," says David Jones, chief economist at Aubrey G. Lanston & Co. Even though the economy may be experiencing some minor inflationary pressures--the kind that the Fed would normally be quick to quash by raising interest rates--the Asian economic crisis may end up retarding U.S. growth just enough to forestall action. "Without Asia, the Fed probably would have tightened," says Mickey Levy, chief economist at NationsBanc Montgomery Securities. "Now it's on hold." Greenspan and his colleagues may take some action in the second half of the year, but experts guess a rate cut is as likely as a rate increase. And even if the Fed should tighten before year-end, that alone won't be enough to hurt the bull market much. In 1994, for instance, the Fed raised short rates six times for a total of 2.5 percentage points. And although the market fell nearly 10 percent in the spring, stocks eventually finished pretty much even.
The millennium bug (4)
When one of Wall Street's most respected superbulls goes wobbly in the knees, it's worth noting. "After being bullish for 10 years, I think the bull market's days are numbered," says Edward Yardeni, chief economist at Deutsche Morgan Grenfell. He calls the year-2000 problem--the inability of many computer systems to understand dates after Dec. 31, 1999--"the No. 1 threat to this bull market." Although the problem sounds trivial, Yardeni--who in November testified on this subject before a Senate panel--thinks worldwide computer snafus will spark a global recession in 2000 and a corresponding bear market in 1999 or 2000. Few, if any, other Wall Street economists are as gloomy as he is. Indeed, many investors have been more focused on trying to profit from the problem. But concern may be growing. A recent investment report from Bear Stearns & Co. spent considerable space examining the harmful earnings impact of the so-called millennium bug.
Investors may not have to wait until next year to see if Yardeni's prediction pans out. Last month, a division of the Securities and Exchange Commission issued a legal memo urging public companies to spell out the extent of their year-2000 issues and how they expect to deal with them. Starting with first-quarter-earnings reports due out in April, companies may begin revealing how much they are spending to debug their systems. "This could startle people into recognizing the kind of risks involved here," Yardeni says.
Even if none of these factors ends the bull market, they should give investors plenty of reason to tame any wild expectations for 1998. Stocks probably won't notch 20 percent-plus gains for a record fourth-straight year. As Callies of Credit Suisse First Boston puts it, investors can handle only "one big event" at a time. This year, there could be several.
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