To Pros, the Stock Selloff Question Is When, Not If
For a logic-defying levitation act, don’t pay to see David Copperfield. Just take a look at the U.S. stock market.
Despite bond yields at their highest levels in more than three years, most major stock indexes are hovering near their 1993 closes--which means they’ve given up almost no ground in the midst of the worst bear market for bonds since the 1920s.
Even on Friday, when a strong October employment report sent the yield on the bellwether 30-year Treasury bond surging to a 39-month high of 8.15%, the stock market held up remarkably well until hit by some computerized “program” trading late in the day.
The Dow Jones industrial average lost 38.36 points to 3,807.52 on Friday, but it remains 1.4% above its year-end ’93 close of 3,754.09.
And contrary to a popular Wall Street view, the blue-chip Dow isn’t propping up the market by itself. The broad Standard & Poor’s 500-stock index, at 462.28 now, is a mere 0.9% below its year-end close and just 4% below its peak set in February.
More significant to individual investors, the average U.S. stock mutual fund is down less than 1% in value this year, according to fund-tracker Lipper Analytical.
Most Wall Street veterans, if told 10 months ago where short- and long-term interest rates would be today, would almost certainly have figured that stocks would be in a deep slump.
So why has the bear been kept at bay? Analysts point to an extraordinarily fortunate confluence of events this year: Corporate earnings growth has vastly exceeded expectations, individuals have continued to pump cash into stock mutual funds, and institutional investors have shown a surprising unwillingness to walk away from their favorite stocks.
Yet as 1995 looms, many investment pros believe the market’s luck has nearly run out. The increasingly prevalent view is that stocks are at risk of a significant selloff soon whether interest rates rise further or fall.
William Dodge, market strategist at Dean Witter Reynolds in New York, sees the key problem now as one of basic valuation--weighing stocks’ appeal versus that of bonds and bank CDs.
As bond yields rise, investors naturally pay lower prices for stocks relative to earnings per share. That has in fact happened this year. At the start of the year, the S&P; 500 index was priced at 16.4 times the S&P; companies’ 1993 operating earnings. Today, the index is priced at 14.4 times estimated 1994 operating earnings, according to brokerage Goldman Sachs & Co.’s estimates.
Stocks’ earnings “multiple” is a product of simple division, so it can drop in one of two ways: Either stock prices decline, or earnings rise. This year, earnings have risen so powerfully--thanks to the healthy economy--that the S&P; multiple has fallen even as stock prices have stayed virtually level.
In effect, investors have been able to convince themselves that they’re actually paying “less” for stocks by paying the same price, because earnings have grown.
But with 30-year T-bond yields at 8.15% and three-month T-bills yielding 5.3%, Dodge sees more investors questioning whether the average stock is worth 14 times earnings.
Even allowing for further corporate profit growth in 1995, he says, “the bottom line on the valuation backdrop today is that we are at the same levels relative to interest rates . . . that preceded the 1990, 1987, 1983-84, 1980-82 and early-70s market declines.”
While other Wall Streeters will debate whether 14 times earnings is expensive or fair, Dodge’s point is that there is very little wiggle room left. “Can (stocks) move higher in the current environment? Sure, but not without getting more and more overvalued and presenting more and more risk,” he says.
Geraldine Weiss, editor of Investment Quality Trends newsletter in La Jolla and a bear, believes that interest rates have hit levels that will induce a major change in investor psychology.
Most investors know, Weiss says, that the market’s “internals” have been deteriorating this year. Though key stock indexes have held up, the ratio of declining stocks to advancing stocks in the broad market has ballooned. Yet the relative health of the 30 stocks in the Dow industrial index has given investors something hopeful to cling to, Weiss says.
But with short-term interest rates double where they were a year ago, Weiss expects the still-strong flow of small investors’ dollars into stock funds to ebb soon. That would take a crucial element of support away from the market.
If you can earn 6% on a one-year bank CD, Weiss says, “why on Earth take a chance in a risky and overvalued stock market?”
The bulls might answer her with this: Interest rates are peaking. Their next major move is down.
But if that’s the case, some investment pros say, the stock market is still a loser’s game now. Why? Because if interest rates begin to drop, Wall Street’s automatic assumption will be that the economy is finally slowing. And if business slows, so will corporate earnings growth.
Analysts already are estimating that S&P; 500 earnings growth will decline in 1995 to 13.7% from this year’s expected 17% rise, according to earnings-tracker Zacks Investment Research in Chicago.
If in the wake of recent strong economic reports the Federal Reserve Board raises rates dramatically at its Nov. 15 meeting--say, by a full percentage point instead of the usual half-point--it’s conceivable that investors could view that increase as the last one.
But then, expectations for a meaningful economic slowdown in ’95 could escalate. And the optimistic outlook for corporate earnings would begin to evaporate, casting a chill over stocks.
Jeffrey Applegate, investment strategist at CS First Boston in New York, thinks the stock market is set up to have its earnings-driven bullishness “dashed over the next few months” as investors focus on high real interest rates and slowing earnings growth. In the process, he said, he believes the Dow could slide as much as 400 points, or 10.5%, to about 3,400.
That wouldn’t be the end of the world, Applegate notes. Assuming the economy slows in 1995 but avoids recession, stocks’ bull market could easily resume from lower levels--just as stocks recovered after the Dow’s 10% drop in spring.
The big question is whether a Dow decline of several hundred points would set off a dangerous chain reaction at this point in the market cycle, with interest rates offering steep competition for stocks and the best news in corporate earnings growth almost certainly behind us.
Weiss notes that the Dow, as the most-watched index, can cut both ways: It can give investors a false sense of security if it stays up while other indexes decline. And it can deepen any turn to bearishness if it plunges, even if the rest of the market initially holds up.
“Once the Dow capitulates and it becomes widely recognized that we’re in a bear market, an element of panic can set in,” Weiss warns.
One ominous sign for the market is that investor psychology, although still positive toward stocks, has become a game of reaching for reasons to stay bullish, argues Richard McCabe, market analyst at Merrill Lynch & Co.
“You hear money managers say now, ‘It’s not worthwhile getting out and then trying to get back in,’ ” he says. Others will insist that “the market is bad, but the outlook for my stocks is good.”
More worrisome, McCabe says, is that many money managers tell him that they are inclined to sell but that their clients won’t go along with that decision. “They say that their clients are telling them that this is still a great long-term bull market and that they want to stay invested in it.”
Before the market can turn, “investor psychology has to finally change,” McCabe says. “People have to begin to feel that the greater risk is losing money, not missing the potential upside.”
Of course, the bulls may have it right after all. If the Fed engineers a “soft landing” for the economy, if inflation stays low, if bond yields drop, if the corporate profits trend remains up and if there are no global political shocks, the end of this bull market may not yet be on the horizon.
The market’s doubters say the problem is that there are just too many “ifs” in that equation to give them any real comfort with stocks when a bank now will offer them 6% risk-free.
