Upward Surge in Stocks Isn't Unprecedented

By TOM PETRUNO

Feb. 14, 1996 12 AM PT

After last year’s stunning stock price gains, many investors were expecting--or even hoping for--a breather early this year. The market had other ideas. Despite a mild pullback in prices Tuesday, share values overall are near record highs. A look at how and why stocks have surged again, and the outlook:

Q: How much has the stock market advanced?

A: Since Jan. 1 the Standard & Poor’s 500 index of blue chip stocks has jumped 7.2%, after soaring 34.1% in calendar 1995.

The Dow industrial average is up 9.5% after surging 33.5% last year. But smaller stocks are lagging, and that is holding the average U.S. stock mutual fund’s gain to about 5% this year, after last year’s 31.1% rise.

Q: Is it unprecedented for stocks to keep soaring after a year as hot as 1995?

A: On the contrary. History shows that great years for the market tend to be followed by additional gains. Since 1950 there have been eight years when the S&P; index has risen more than 25%, not counting 1995. In six of those instances the S&P; also rose in the following year. And in three of those six years the follow-on rally was double-digit: 14.6% in 1986, 19.2% in 1976 and +26.4% in 1955.

So with the S&P; up 7.2% this year it wouldn’t be shocking to rally further. The market often is a locomotive: It’s hard to stop once it gets going.

Q: What’s the fuel that feeds this locomotive, and where does it come from?

A: Cash--and plenty of it, especially from individual investors. As has been widely reported, stock mutual funds are estimated to have taken in a net $24.5 billion in new cash from investors in January, a record sum for any month.

But that’s only part of the story. As of Dec. 31 stock funds already had $100 billion in cash on hand. With the surprising January inflow, many fund managers felt enormous pressure to put cash to work in stocks. Once the buying began in earnest in January a “pile-on” began, as more managers opted to buy rather than wait, fearing that prices would only continue to rise.

And the stocks that managers run to first are usually the blue chips, because they’re easy to buy.

Q: But won’t many fund managers at some point decide that stocks are simply too high, and stop buying?

A: Certainly. Some were already extremely skittish by the end of 1995--notably, Jeff Vinik, manager of the Fidelity Magellan fund, the nation’s largest. He had more than 15% of the $55-billion fund’s assets in cash at Dec. 31. So far, however, that looks to have been a bad bet.

Many pros argue that the market still isn’t wildly overpriced by historical standards. Goldman, Sachs & Co. strategist Abby J. Cohen estimates that even with the slower economy, operating earnings (results before any one-time write-offs) for the S&P; index will be $41.75 a share in ’96. With the S&P; now at 660.51, the price-to-earnings ratio for the average blue-chip stock is just under 16. That is only slightly above the historical average.

It’s always dangerous to lean too heavily on averages for support, of course, but you can see how fund managers’ thinking might go: If stocks are only about average-priced now, and you expect that corporate earnings will continue to rise in 1997 (i.e., no recession looms), you can potentially justify higher prices. What’s more, if this rally continues it will probably soon branch out, encompassing more smaller stocks that have lagged. That’s the usual pattern.

Q: What role do interest rates play in this ongoing market surge?

A: Lower rates, courtesy of the Federal Reserve Board and the anemic economy, give investors greater justification to pay higher stock prices, because stocks’ allure automatically goes up as yields on bonds and bank CDs fall.

Richard Eakle, head of market research firm Eakle Associates in Fair Haven, N.J. notes that the Fed cut its key “discount rate” (the rate banks pay to borrow from the Fed) to 5% from 5.5% on Jan. 31. A cut in that rate usually indicates that the Fed is in a sustained campaign to lower the cost of money. Since World War II the Dow Jones index was, on average, 24% higher one year after the Fed’s first discount rate reduction in each credit-easing cycle, Eakle says.

Q: That makes it sound as if stocks’ continued advance is virtually certain. What could go wrong to change the picture?

A: Plenty. For one, it’s worth noting that January is usually a huge month for new investment (think year-end bonuses). If cash in-flows trail off that will ease upward pressure on stock prices.

More important, nearly everybody expects corporate earnings to rise this year, albeit more slowly. If the optimists are wrong--and earnings begin to decline for many companies--that could hammer stocks. So could rising interest rates.

But the bulls say the mistake people have been making with the market since 1990 is underestimating it. Many investors have waited in vain since 1990 for indexes such as the Dow or S&P; to fall 10%--a typical market “correction.” Yet while they have waited plenty of individual stocks have periodically pulled back by at least 10%, only to surge again. That could well be the case again this year: Many stocks will be hit by profit-taking at some point, but perhaps not enough to provide that long-awaited 10% broad market pullback.

Ralph Acampora, technical analyst at Prudential Securities, argues that we’re in a secular bull market powered by heavy demand for stock not only by small investors but also by foreign investors and by corporations themselves, via mergers and stock buybacks. You need something big to stop this locomotive, he says--and so far, there’s no sign of that impediment on the tracks.

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S&P;’s Big Years

Since 1950, there have been eight years when the Standard & Poor’s 500 stock index has risen more than 25%, not counting 1995. In six of those instances, the S&P; also rose in the following year. Percentage changes in the index:

1954: +45.9%

1955: +26.4%

1956: +2.6%

1958: +38.1%

1959: +8.5%

1975: +31.6%

1976: +19.2%

1980: +25.8%

1981: -9.7%

1985: +26.3%

1986: +14.6%

1989: +27.3%