Three Views of Where Wall Street Is Headed

The rallies in stock and bond markets last week suggested that the spring “correction” may have run its course.

Long-term interest rates finished the week slightly lower than the week before, and stock prices rebounded convincingly after plunging early in the week to their lows of April 4--which was the market’s worst day yet this year.

So is it off to the races again? Obviously, that’s one possibility. But for the first time since this bull market began in October, 1990, Wall Streeters admit that they have to consider two other scenarios: That a bona fide bear market is under way, or that we’re in for neither bull nor bear, but instead a seesawing stock market in which only the savviest of traders will make real money.

What follows are the arguments for each of the three scenarios:

* The bull market resumes. At its lowest close of 3,598.71 last week, the Dow Jones industrial average was off 9.5% from its all-time high of 3,978.36 reached on Jan. 31. The Nasdaq composite index of mostly smaller stocks bottomed last week 12.2% below its record high.

To the bull camp, history has been satisfied: We’ve had a very normal 10% to 15% “correction” in stock prices, the kind that often interrupts bull markets for a time. But enough is enough.

The nominal catalyst for stocks’ selloff, of course, has been the Federal Reserve Board’s decision to tighten credit for the first time in five years. The Fed has raised short-term interest rates from 3% to 3.75% so far this year, ostensibly to slow the economy and thus keep inflationary pressures at bay.

With both short- and long-term interest rates rising, it was natural that the stock market would convulse temporarily, the bulls say. But the crux of their case for a resumption of the bull market is that the Fed will succeed in moderating the economy’s growth without having to force interest rates dramatically higher.

“In my view, we are still quite early in what I believe will be a prolonged slow-growth (economic) cycle,” says Byron Wien, investment strategist at Morgan Stanley & Co. in New York.

The bulls don’t believe stocks are expensive relative to corporate earnings. So if interest rates stabilize and the economy continues to expand, albeit more slowly than during the last two quarters, rising profits should be the lure that draws buyers back to stocks.

More important, says Wien, is the potential for corporate profit margins to widen--i.e., for companies to earn more off each $1 of sales, as business improves but costs are held down by tight-fisted managers leery of expanding.

“Margins, in a secular decline since the 1960s, are beginning a period of secular improvement--a fact that has escaped many analysts. As a result many earnings estimates for 1994 and beyond will turn out to be low,” Wien contends.

Stefan Abrams, investment strategist at Trust Co. of the West in Los Angeles, also is an unabashed bull. He expects one more “modest hiccup” in stock prices in May or June, as evidence of a slowing economy causes some investors to fear that a full-fledged recession is imminent.

But when Wall Street realizes that the economy’s progress will continue, “the bull market will resume in earnest,” Abrams says.

* We’re in a bear market. The bear case is based primarily on one theme: The Fed’s shift to tighter credit, after five years of relatively easy money, has produced a sea change in investor psychology.

There simply won’t be enough buyers of stocks and bonds going forward, the bears argue--but there remain plenty of sellers. That will translate into higher-than-expected bond yields and a stock market that could lose another 10%, 20% or more of its value, probably in a slow decline extending into 1995, many bears say.

“The single most important fact for investors to understand is that . . . the Fed is no longer on your side,” says Charles LaLoggia, editor of the Special Situation Report market letter in Rochester, N.Y.

He says investors will increasingly see bank CDs and other “cash” accounts as a decent alternative, as the Fed’s tightening lifts short-term interest rates above 4%. At the same time, even investors tempted by stocks will focus on share price-to-earnings ratios which, if no longer at record highs, could hardly be termed cheap.

What about the bulls’ case that a slow-growing economy and rising corporate profits will support stocks? Study history, the bears retort: Severe bear markets have often struck in years when the economy grew and profits boomed. Think of 1962, 1966 and 1987.

The overriding issue for stocks and bonds at any time, say the bears, is whether the number of potential buyers is large enough to offset the potential sellers. After three years of wild global speculation in bonds, and of unprecedented stock mutual fund purchases by small investors, the markets are loaded with people who have good reason to sell if they fear that the tide has turned against them.

With the bloodshed in stocks and bonds so far this year, “people are finding out that they can lose money,” says Dan Sullivan, editor of the Chartist investment newsletter in Seal Beach. And the potential buyers, he says, now understand there’s no hurry.

“We’re overdue for a traditional type of bear market,” Sullivan argues. If this one is traditional, stocks will lose more than 25% of their value before it’s over, he says. If that’s more than you can swallow, sell now, Sullivan advises.

* We’re stuck in a “trading range.” Some Wall Streeters can’t agree fully with either the bull case or the bear case. This group sees the market alternately rallying and selling off for the rest of this year and perhaps through 1995--and, in the end, making painfully little headway.

Like the bull camp, the trading-range camp believes the economy will slow, and that any additional rise in interest rates this year won’t be extreme. But like the bears, the analysts who expect a trading range believe that stocks have long been pushing the outer limits of “fair” value, relative to earnings and dividend yields.

Add it all up, and you get a stock market likely to seesaw, as the positive effects of rising corporate earnings are offset by the knowledge that higher interest rates (and probably higher inflation) will reduce the value of those improved earnings to shareholders.

Arnold Kaufman, editor of Standard & Poor’s Outlook newsletter in New York, is bracing his clients for a market in which meaningful gains will be elusive.

“We’re looking at below-average gains for the next few years at least,” he says. “We think returns (on the S&P; 500 index) will be in single digits, and we could well see low single digits.”

Interestingly, many Wall Streeters have argued that the 1990s are a replay of the 1960s--with decent economic growth, low inflation and relatively high price-to-earnings ratios on stocks.

What is forgotten, however, is that all of the money made in the ‘60s was made in the first half of the decade. Then, from 1965 to ‘75, the market rode a roller-coaster that was a terrific environment for smart traders, but a disaster for many buy-and-hold investors.

If the market’s advance so far this decade has already discounted much of the good economic news ahead, a seesaw pattern may be the best Wall Street can expect for many years to come.

A ‘60s Flashback?

Many Wallstreeters like to compare the 1990s to the 1960s, a period of decent economic growth and low inflation. What’s painful to note is that virtually all of the money made in stocks in the 1960s was made in the early part of the decade. The latter part of the ‘60s and the early part of the ‘70s saw stocks trapped in a trading range in which buy-and-hold investors saw little net price appreciation.

S & P 500 index net price change:

1960 to 1965: +59.1%

1965 to 1970: -0.3

1970 to 1975: -2.1

1960 to 1975: +55.2

Source: Standard & Poor’s Corp.