Dow Revisits Near-4,000 Mark as ‘Soft Landing’ Gains New Fans
One year ago today, the Dow Jones industrial average was at 3,867.20 and racing for the historic 4,000 mark--buoyed by strong corporate earnings growth and a sense that interest rates wouldn’t be a significant problem in the near term.
Not much has changed.
On Friday, the Dow zoomed 49.46 points to 3,908.46, within shouting distance of 4,000, as the powerful potion of healthy earnings and a friendlier interest-rate environment again lured investors back to U.S. stocks.
The specific catalyst for Friday’s rally was the government’s report that retail sales slipped 0.1% in December, the first decline in eight months. Although there are few statistics as unreliable as the retail sales estimate, it was enough for another swarm of investors to declare victory in the Federal Reserve Board’s war against runaway economic growth.
Before Friday, Wall Street had widely assumed that the Fed would raise short-term interest rates for the seventh time in 12 months at a meeting scheduled for Jan. 31.
Now, some influential economists, including Bear, Stearns & Co.’s Wayne Angell, expect the Fed to leave rates alone at the upcoming meeting, on the assumption that the economy is showing genuine signs of decelerating.
That shift in sentiment spurred a phenomenal bond market rally on Friday, in turn triggering the stock market’s surge. For example, the yield on five-year Treasury notes slumped to 7.63% from 7.80% on Thursday, and now is at its lowest level since early November.
Coincidentally, the Dow’s gain Friday put it back to levels last seen in late October.
Of course, the running market joke of the last 12 months has been that “interest rates are peaking.” Every time investors have bought that assumption they’ve been badly burned.
A year ago, nearly everybody expected the Fed to tighten credit in 1994--but almost nobody guessed that rates would rise six times by November.
There still are plenty of investment pros who believe the Fed isn’t done boosting short-term rates from the current 5.5% range, Friday’s markets notwithstanding.
With the retail sales report and a few other tepid economic indicators in recent weeks, “people are drawing a line through a few data points and saying the bear market in bonds is over,” says Tad Rivelle, bond fund manager at Hotchkis & Wiley in Los Angeles. “But my feeling is, this (euphoria) isn’t going to last. I don’t think this is going to change the Fed’s mind.”
David Jones, economist at bond dealer Aubrey Lanston & Co. in New York, argues that a bet today on a sudden slump in the economy probably would be as foolish as a bet on fast growth was in 1991. The economy took a long time to kick into high gear in this expansion, and it will likewise take a while to slow, Jones says.
“You don’t just stop it in its tracks,” he says, despite a 2.5-point rise in interest rates in 1994. Knowing this, the inflation-paranoid Fed will probably choose to turn the credit spigot another notch on Jan. 31, Jones says.
He expects a 0.50-point rate hike, mainly because he thinks Fed Chairman Alan Greenspan is rightfully concerned about creeping inflationary pressures in an economy where many factories are operating near full capacity.
“A lot of businesses tend to raise prices early in the year,” Jones notes, which means higher inflation could already be in the pipeline, even if economic growth begins to moderate.
“The problem for Greenspan is that, if he doesn’t raise rates (on Jan. 31) and then we get an inflation surprise, he would look pretty bad,” Jones says. The Fed can’t risk the perception that it has again fallen behind the growth and inflation curve, he says.
But would another Fed rate hike kill the stock and bond markets’ rallies? Maybe not, in the short run. In fact, the markets may even be counting on the Fed’s vigilance to assure the desired “soft landing” for the economy: Growth slows to a pace that is sustainable and non-inflationary, allowing longer-term interest rates to stabilize while corporate earnings keep rising.
If enough investors start fantasizing about that kind of economic nirvana, it may take only a few more reports like Friday’s retail sales number to spark a virtual stampede into long-term bonds, and into many stocks as well.
What’s important to note about the bond market is that long-term yields, such as on the 30-year Treasury bond, have actually been inching lower since November. The market showed amazing resilience in the face of the November and December U.S. employment reports, both of which suggested red-hot growth.
The 30-year T-bond yield, which fell to 7.79% on Friday, is down nearly 0.40 point from its early-November peak of 8.15%.
William Griggs, at economic consulting firm Griggs & Santow in New York, notes that even at 7.79%, the 30-year bond yield is five percentage points over the 1994 consumer inflation rate of 2.7%. Historically, bond investors were happy earning two to three points over inflation.
“The market has built in a big cushion,” even assuming that inflation accelerates a bit in 1995, Griggs says. “There is plenty of room to maneuver” if long-term bonds want to rally, he says.
For U.S. stocks, meanwhile, fading worries about interest rates could allow investors to focus on what remains a bullish corporate earnings outlook.
Fourth-quarter earnings reports, which will begin to inundate the market this week, should reflect the economy’s still-brisk pace as the year ended. Prudential Securities analyst Melissa Brown says overall earnings of 1,075 big-name firms that she tracks are expected to be 18.4% above results in the fourth quarter of 1993.
That would mark the 11th consecutive quarter of double-digit, year-over-year earnings growth.
If you’re looking for reasons why stocks haven’t collapsed despite high interest rates, that earnings performance is a good place to start: Rising earnings underpin stock prices, providing an offset to the negative influence of rates.
It’s not a perfect offset, to be sure. Auto stocks, for example, were trampled last year despite record earnings, as investors feared the good times were nearing a peak. But even the auto shares have been creeping up in recent weeks as investors reconsider the idea of a stretched-out expansion.
Moreover, even though the next logical concern should be a slower U.S. economy’s potential drag on earnings, investors may give more companies the benefit of the doubt.
As Ben Zacks, head of earnings-tracker Zacks Investment Research in Chicago notes, “You can have a slowdown in the United States, but many U.S. companies do a major part of their business overseas,” where growth isn’t decelerating (ex-Mexico, at least).
If interest rates cooperate in the next few weeks, here’s one glowing scenario for stocks: The Dow, now just a 1.8% move from its record high of 3,978.36 set last Jan. 31, jumps past that mark on the strength of fourth-quarter earnings and finally tops 4,000.
The excitement generated by the Dow gets investors’ attention and channels cash otherwise destined for money market funds or for international stock funds into U.S. stock funds instead, setting off a buying frenzy by fund managers that carries the Dow to 4,200--a 7.5% gain from Friday’s close.
Then what? That’s the problem: We’re still dealing with a stock market that isn’t terribly cheap on a price-to-earnings basis, with the average blue-chip stock selling for 13 to 14 times estimated 1995 operating earnings per share.
That suggests, unfortunately, that at best the market (and thus the average mutual fund) is capable of a minor rally. And, if anything goes wrong with the soft- landing outlook--the economy picks up steam, inflation accelerates rapidly, bond yields surge--stocks could quickly replay their see-saw pattern of 1994.
Given that possibility, many investors will no doubt just figure they’re better off earning 5.5% or more risk-free in a short-term “cash” account, or nibbling at bonds at yields over 7%. But predictable and boring as it sounds, adding to your stock holdings when your favorites are down--the best strategy in ‘94--still looks like a money maker in ’95.
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Earnings: Still on a Roll
Corporate earnings reports for the fourth quarter will flood the market this week, and most should be strong: Prudential Securities expects operating earnings for 1,075 large companies that it tracks to be up 18.4% overall from the fourth quarter of 1993. Quarterly earnings, percentage change vs. a year earlier:
1994*: 18.4%
* Estimate
Source: Prudential Securities
