Jobless Report Fuels Economic Uncertainty and ‘Octobophobia’

Fresh off last week’s lousy August employment report, the stock market now faces its two toughest months of the year with the economy’s health again in question.

And with share prices near record highs, the possibility of a deeper economic slowdown is hardly what many recent equity investors had in mind--especially heading into October, which has a reputation for being brutal on stocks.

Many market pros, while still bullish, concede that stocks may essentially have to bluff their way through the next few months, supported only by the likelihood of a continuing downward spiral in long-term interest rates.

As Wall Street returns to work on Tuesday, here’s what it will find.

* Last Friday’s report on U.S. employment in August, which showed a surprisingly large loss of 39,000 non-farm jobs, cast a pall over the economy’s prospects. Any thought of robust growth this autumn died with the report.

* Bond investors, fully believing that the economy is mired in a slow-growth, low-inflation mode, rushed to lock in long-term bond yields before they head even lower. The yield on the Treasury’s benchmark 30-year bond plunged to 5.94% on Friday, down from 6.04% on Thursday and the lowest since about 1972.

* Stock investors, not quite sure whether to laugh or cry at the employment report, managed a feeble grin. The Dow industrials inched up 7.83 points to 3,633.93 on Friday, leaving the blue-chip index just 19 points under its all-time high of 3,652.09 set on Aug. 25.

For the past three years, the stock market has lived by the maxim that bad news is good news. As long as the weak economy forces interest rates down, stocks can go higher--or so we’ve all come to believe.

The question that Wall Street doesn’t want to face: When does bad news become bad news again?

Someday--but not yet, many experts insist. Though the loss of jobs in August was disappointing, it masked underlying strength in the economy, they say.

Most significant is that business continues to meet production demand with fewer workers. Donald Straszheim, chief economist at Merrill Lynch & Co. in New York, notes that despite the drop in jobs in August, “the total number of hours worked, a proxy for economic activity, was up 0.6%.”

August merely continues the trend of an economy that is trudging along, with no boom--or bust--in sight, says William Dodge, investment strategist at Dean Witter Reynolds in New York.

So far this year, “it’s been wrong to be bearish on the economy and wrong to be bullish on the economy. (Growth) has been right down the middle” of expectations, Dodge says.

But with the Dow industrials up 10% year-to-date and many stocks at historic highs, the market’s bears argue that investors have already priced faster economic growth--and faster corporate profit growth--into share prices. So the market isn’t prepared for a new round of weak-kneed economic statistics, the bears contend.

Dodge, however, says that might be true only if long-term interest rates were to stop falling. Instead, with bond yields crashing to 20-year lows, he says investors consciously or subconsciously know they must continue to view stocks in a different light.

It is basic economics, he says, that as the cost of capital (i.e., interest rates) drops, a dollar’s worth of corporate earnings is automatically worth more to a company and its shareholders.

Thus, even if investors were to expect lackluster earnings, the value of those earnings has to be adjusted upward to account for lower interest rates.

In fact, Dodge argues that despite stocks’ gains this year, “the market has lagged the improvement in interest rates.” If rates remain subdued, he sees the Dow reaching 4,050 over the next 12 months, an 11% rise from here.

What’s more, though the iffy economy raises concerns about corporate earnings, many pros note that profit worries also were rampant in winter and spring. Yet for the most part, companies have posted surprisingly good earnings this year--a testament to their efficiency after years of cost-cutting.

Charles Mayer, manager of the $3.6-billion Invesco Industrial Income stock fund in Denver, says a key reason he still can find stocks to buy in this market is that “corporate cash flows are really strong.”

Many companies, he says, are swimming in cash even though their product sales aren’t booming. That financial strength means companies will have great flexibility to expand and invest when the time comes, Mayer notes.

Of course, if the August employment report is a prelude to a much weaker economy this fall, even the bulls concede the stock market could be vulnerable to a sharp setback.

But for now, American consumers’ continuing willingness to buy big-ticket items such as homes and cars is more than offsetting their reluctance to spend freely on clothing and other small-ticket goods, experts say.

“I don’t think the economy is going to unravel,” says John Neff, veteran manager of the giant Vanguard Windsor stock mutual fund in Valley Forge, Pa. “I think you’ll even see a little better tone in the economy this fall.”

Yet Neff, like so many stock pros, is hedging his bet: Fully 20% of his $10-billion fund’s assets are in cash, which he admits is high for Windsor. “I probably won’t increase (the fund’s stock weighting) until we get some kind of correction in the market,” he says.

Plenty of other investors also are waiting for the proverbial correction, a 5% to 10% drop in the broad market averages that would clear out some of the speculation in stocks and set the market up for another bull run.

There hasn’t been a significant correction since this bull market began in October, 1990.

But if you’re waiting, September and October historically provide the most fertile ground for trouble in stocks.

James Stack, who writes the InvesTech market newsletter in Whitefish, Mont., titled his latest letter “Octobophobia” and in it details the long list of October massacres on Wall Street: 1929 and 1987, of course, but also 1978, 1979 and 1989.

Stack, obviously bearish, tallied the Dow index’s gains and losses in September and October since 1920 and came up with these painful statistics.

* September is one of only two months of the year (the other being February) that the Dow has fallen more often than it has risen over the past 73 years.

* The September-October period is the only two-month period of the year that has averaged a net loss (-4.5%) for the Dow since 1920.

Given the new questions about the economy--and the market’s historical trend at this time of year--it’s easy to argue that investors should simply stay away from stocks until November or so.

But then, the high level of disbelief that still dogs this bull market may also be its best friend.

Even Neff, while hungry for lower stock prices, cautions against putting much credence in the so-called October curse. “He who worships at the altar of historical parallels does so with some peril,” Neff notes.