Is the rally real?
Wall Street's party may run out of steam unless the economy shows up for the celebration
The sequel 2Fast 2Furious isn't just a summer action flick about dangerous driving. It could also describe the recent behavior of the stock market. Despite improving but still subpar economic reports, Wall Street has been on a tear, with the Dow Jones industrial average and the S&P 500 last week breaching the psychological barriers of 9300 and 1000, respectively. But can it continue?
"Do we have lots of positive economic reports signaling improvement in things like industrial production and employment? So far, no," says Clare Zempel, chief investment strategist for Robert W. Baird in Milwaukee. "But I think the odds are extremely high that the worst is over for the stock market and for the economy and that this post-war rebound is sustainable."
Market watchers were heartened by last week's report that showed the leading economic indicators up a better-than-expected 1 percent in May, coming on top of a bullish survey of improving manufacturing conditions in New York State. Muted results from a Federal Reserve survey of Philadelphia-area manufacturers helped spark a triple-digit sell-off Thursday, but even that was attributed, in part, to profit taking and a belief that the Fed would not have to be as aggressive in cutting rates as had earlier been expected. Mildly better economic news was actually viewed as a short-term negative for the market.
But a broader trend seems to be afoot, confirmed by the fact that even with the sell-off, many stocks still were showing positive gains from the rally that began in March. Investors seem to have mentally moved past many of the noneconomic events that spawned financial uncertainty during the past two years: 9/11, Enron, and the war in Iraq. "In the past we've had false starts which were clearly interrupted by factors beyond the control of fiscal or monetary policy," says Ned Riley, chief investment strategist at State Street Global Advisors in Boston. "This rally is clearly different."
Record-low interest rates, in turn, have made the yield on bonds less desirable as an alternative to stocks. Solid companies now pay dividends that are higher than yields on cash or short-term debt. About the only missing element is evidence of the much-anticipated economic rebound. Still, a quick analysis of the market upturn shows it to be a pretty powerful beast that gives reason for further optimism--and gains.
For starters, the advance has been broad, with not just technology or drug stocks leading the way. Sam Stovall, chief investment strategist at Standard & Poor's, notes that all 10 of the major sectors that make up the S&P 500 are in the black since the market low of March 11. Of that group, five sectors are up more than 30 percent, led by automakers, home builders, and financials. The worst performers have been defensive sectors like energy stocks, but even they are up more than 12 percent as a group. And out of the 115 industry groups tracked by S&P, the only one in negative territory since mid-March is hospitals, because of some company-specific problems. "This is how the market acts coming off a bear-market bottom," says Stovall. What bolsters his confidence is not just the higher prices of S&P stocks but also their positive price patterns. When the index shot past 960 on the last trading day of May, it broke through a downward trend line extending all the way back to the market heyday in March 2000.
History lesson. Another encouraging aspect to this rally is that it has been deep as well as broad--and not reliant on a handful of powerhouse stocks to pull the indexes higher. The number of stocks advancing has outweighed the number of decliners in this rally by 2 to 1, which market strategists view as positive. The rally also has history on its side. The S&P 500--down in 2000, 2001, and 2002--hasn't declined four years in a row since 1932. Then there's the presidential election cycle. Since the end of World War II, the S&P 500 has never experienced a decline in the third year of a presidential term, such as we're in now.
Of course, it would be nice to have better company fundamentals supporting the market. But there have been signs of improvement. In the first quarter, corporate America beat Wall Street analyst expectations by 6.5 percent. No quarter has come close to that during the past three years. While Wall Street is expecting around 6 percent earnings growth for the second quarter, some observers such as brokerage Morgan Stanley think profits could grow at an 8 percent to 10 percent clip. And while that is way off beginning-of-the-year projections (which usually turn out to be too rosy), it's not too shabby in this disinflationary environment. A similar pattern of weak economic reports existed back in the "jobless recovery" of the early '90s, as the market began its decade-long rise. Yet many individual investors continue to play it safe. Cash as a proportion of financial assets jumped to 17.5 percent in the first quarter vs. 11.7 percent in early 2000. And a survey of gen-X investors by New York Life Insurance Management found that only 47 percent now think stocks are an important part of a person's investment portfolio. "In the '90s, the public got sucked into that vortex of speculation where they thought that `this time is different' and that we would never have another recession," State Street's Riley says. "Now they are doing the exact opposite and extrapolating the negative."
But when that love affair with stocks does finally rekindle, there will be no shortage of fuel to light the fire, as nearly $1 trillion is sitting in money market funds that could shift into stocks. (We may be seeing the first hints of that in the 20 percent rise in daily trading volume that Charles Schwab reported for May.)
When exactly might that happen? Probably when there is more concrete evidence of increased production and employment. Zempel thinks that could start showing up in the third quarter, which, by the way, is traditionally a weak one for stocks. But if the economy does come through eventually, then investors might finally have the long-awaited sequel to the bull market of the roaring '90s.
This story appears in the June 30, 2003 print edition of U.S. News & World Report.