The Big Surprise of ‘94: A Mania for U.S. Stocks?

The standard wisdom about the stock market in 1994 is that it’s going to be a tough year.

But some Wall Streeters have another idea: They see a buying mania coming, similar to the one that drove the Dow Jones industrial average up 36% between January and August, 1987.

Sound too far fetched? Of course it does--which is exactly why the super bulls are so intrigued with the possibility. The market usually confounds the majority view, often with a vengeance.

“I just see all of these people who want to be first to call the top in this market,” says Richard Eakle, whose Eakle Associates is an independent market research firm in Fair Haven, N.J. What he doesn’t see, Eakle says, are many investors who believe that stocks could rocket.

Marko Budgyk, chief investment officer at Houlihan, Lokey, Howard & Zukin in Century City, also has been touting the mania theme to clients in recent months. While most investors believe that stocks are already high-priced relative to corporate earnings, the nature of bull markets is that they take prices to wild extremes that surprise nearly everyone, Budgyk says.

In the late-1980s, he notes, “People were bearish on the (then high-flying) Japanese market--and it went up another 100%” before finally peaking.

Looking at the U.S. market today, Budgyk says, “I think the most likely scenario is that this market has 20% it can add in a fairly short period of time.” A 20% rise would take the Dow industrials from Friday’s record close of 3,867.20 to about 4,640.

There is much more than simple contrarianism underlying the mania-predictors’ logic. In many ways, the backdrop for stocks today resembles the scene in January, 1987--when the Dow began its stunning climb from 2,000 to the 1980s’ bull market peak of 2,722.42 reached on Aug. 25 that year:

* Then, as now, the economy was steadily improving. After languishing at low to moderate growth rates for most of 1986, the economy picked up a head of steam in ’87. Real gross domestic product, which had grown at less than a 2.5% (annualized) rate in the final three quarters of 1986, expanded by nearly 3.2% in the first quarter of ‘87, then topped 4% growth in each of the final three quarters of the year.

Likewise today, the economy is clearly on the mend. And as business and consumer confidence in the future rises, so too will expectations for corporate profit growth--the ultimate driving force behind stock prices.

In 1987, operating earnings for the blue-chip firms in the Standard & Poor’s 500-stock index leaped 27% from 1986 levels, surprising many investors and helping to fuel the market’s surge.

Arnold Kaufman, editor of S&P;’s Outlook market newsletter, predicts a 17% rise in S&P-company; operating earnings this year, and most Wall Streeters have similar, relatively modest projections. But if earnings exceed estimates--and many fourth-quarter reports released so far have done just that--stocks could benefit dramatically.

* Inflation was seen as vanquished in 1987. Helped by a steep plunge in oil prices, the Consumer Price Index rose just 1.1% in 1986--a statistic which, when released in mid-January of ‘87, helped stoke investor optimism.

Last week, the government reported that the CPI in 1993 advanced a mere 2.7%, the lowest figure since ’86.

The perception of low inflation is important, because it can keep financial markets from panicking should interest rates move gradually higher with the strengthening economy. Indeed, rates ratcheted higher during much of 1987, but that proved to be no restraint on the Dow’s climb from January to August of that year.

* The ’87 bull market was viewed as aged. Sound familiar? By the end of 1986, there was general disbelief that stocks could soar in ‘87, because they had been advancing for more than four years.

The current bull market is more than three years old, and the arguments against a sharp rise in prices today are the same as they were in January, ‘87: The bull is simply too mature for such tricks. In retrospect, of course, investors had badly underestimated the potential left in the market in ’87.

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One oft-cited negative sign back then was the so-called divergence of market indexes: The Dow utility stock index topped out in January of ’87. Many Wall Streeters viewed that as ominous, because a peak in utilities often foreshadows a bear market. But the Dow industrials paid no attention to the utilities as the buying mania took hold that winter.

Similarly, the broad market has advanced in recent months even though the Dow utility index reached its all-time high last September, and has slumped since.

* Foreign buyers could be a wild card--again. Foreigners’ robust appetite for U.S. stocks in 1987--and for U.S. assets in general--was a surprise contributor to the ’87 buying mania.

This year, while much attention has been paid to the unprecedented demand by American investors for foreign securities in 1993, little notice has been given to foreigners’ rising purchases of U.S. assets.

In the 12 months ended last Sept. 30, foreigners provided 20% of net U.S. savings available to fund the federal deficit and provide new business investment, up from virtually nothing in 1991.

Gary Schlossberg, senior economist at Wells Fargo Bank in San Francisco, notes that foreign demand for U.S. investments has been increasing for six consecutive quarters but is still well below the 1987 peak--when foreign investment accounted for 40% of net U.S. savings.

Eakle, of Eakle Associates, believes foreign buyers may find U.S. stocks irresistible in 1994, in part because the U.S. market badly lagged most foreign markets last year. The S&P; 500 index’s price gain of 7.1% in 1993 was embarrassingly small compared with the 116% average rise in Hong Kong share prices, the 47% rise in German stocks and even the 20% rise in British shares.

Because investors worldwide now are conditioned to follow the biblical line that “the last shall be first,” the U.S. market’s meager gain last year should automatically attract foreigners here in ‘94, on the expectation of a catch-up, Eakle says. “I think this is going to be the U.S. market’s year in the sun,” he says.

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There are signs that that is already happening: Many of the emerging markets that were red hot last year, such as Hong Kong, Singapore and Mexico, have suffered deep selloffs since Jan. 1. Besides sending native investors in search of a safer haven such as the U.S. market, the selloffs overseas could slow the pace of Americans’ investment in foreign markets. That may mean U.S. buyers keep more of their money here in ‘94, providing more fuel for a mania.

So far this year, individual investors’ renewed demand for U.S. stocks, especially via mutual funds, has stunned analysts who expected a slowdown because of the blip up in interest rates since fall.

Discount brokerage giant Charles Schwab & Co., which offers a convenient one-stop shopping program for mutual fund buyers, says it’s on track to sell a record amount of stock funds this month. Investor fund purchases are running 2-to-1 ahead of redemptions, Schwab says.

At the Twentieth Century fund group in Kansas City, Mo., the firm said it had a record number of phone calls on Jan. 3, many from people looking for stock fund ideas for the new year.

That kind of mushrooming demand for stocks makes a buying panic “very possible,” concedes Bradlee Perry, veteran investor and head of the Babson Group of mutual funds in Boston.

“Money is just pouring into equity mutual funds and that is going to work its way very quickly into the market,” he says. “You’re seeing a market where bad news--unless it’s really disappointing--has no effect on investors.”

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But is there really a good reason to pray that the mania prediction, a la 1987, comes true in 1994? Eakle, who expects the Dow to reach 4,300 by the third quarter, admits that he’s hoping he isn’t surprised by a far bigger gain.

“Vertical markets don’t have happy endings,” he says. That was certainly true of the 1987 mania, which ended in an October crash: From its August peak of 2,722 to its October low of 1,738, the Dow lost 36% of its value. (The Dow recovered enough by the end of ’87 to show a 2.3% gain for the full year.)

There are reasons to think that this time, even a bona fide buying panic would be much more orderly and stretched out. For one, the “collars” imposed on the market after the ’87 crash by the New York Stock Exchange limit volatility. Whenever the Dow rises more than 50 points on any given day, computer-guided trading is automatically slowed.

What’s more, if 1994 brings another record in new stock issuance, that would have the net effect of acting like a sponge for fresh investor dollars--limiting the cash chasing the rest of the market.

Still, the central message here is that the positives substantially outweigh the negatives for U.S. stocks. Mania or not, it may be time to just sit back and enjoy the ride.