If the Bull Ain’t Lame, Why Shoot It in the Foot?

The stock market got it right. As usual.While the bond market continued to have conniptions in August and early September, sweating over the economy’s strength, higher oil prices and the threat of rising inflation, stocks overall traded in a narrow range that bespoke a remarkable calmness.

“Stock investors are too complacent,” bearish Wall Streeters would say, noting how quickly the market rebounded from its July sell-off and then plateaued.

“Not complacent--just confident,” the bulls would retort.

With Friday’s rally to record highs on the Dow Jones industrials--up 66.58 points to 5,838.52--and a convincing surge in stocks across the board, investors once again are asserting that there is no problem on the American horizon big enough to derail the Great Bull Market of the 1990s.

Scoff if you want. But give the stock market the credit it deserves: For nearly six years it has moved higher with relatively few interruptions, correctly anticipating that the U.S. economy would continue to expand, that inflation would remain relatively benign and that pesky problems like Saddam Hussein would come and go without much consequence.

Skeptics will argue that we’re running out of time, that the economy is overdue for recession and thus that Wall Street is overdue for a genuine bear market. But the 1980s economic expansion lasted 7 1/2 years. The 1960s expansion lasted nearly nine years. We’re 5 1/2 years into this one. You do the math: It may be late in the game, but there is plenty of precedent for many extra innings.

What about the stock market’s July slump? Of course it looked scary at the time. The Dow dropped slightly more than 10%. Small-stock indexes like the Nasdaq composite slumped more than 20%. Stock mutual fund redemptions jumped.

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But that market “correction” was only remarkable because we haven’t seen many of them in the 1990s, when in fact historically such temporary setbacks have been typical in the context of ongoing bull markets.

In other words, corrections don’t have to turn into something worse. And July’s did not.

“When you have a 6-year-old bull market, it takes a lot more than two or three months of a sell-off to turn people negative,” says Rao Chalasani, investment strategist at Everen Securities in Chicago.

That raises a key point: It’s not just that buyers have returned to the stock market. It’s that not too many investors, institutional or individual, badly wanted to part with their stocks in the summer, despite the hefty capital gains accumulated over the last six years. If they had, prices would have dropped a lot more than they did, and wouldn’t have recovered as rapidly.

The bulls’ line--”What else are people going to do with their money?”--may be getting tiresome by now, but it still rings true. The average stock mutual fund is up more than 11% this year. Five-year Treasury notes pay 6.5%. The average money market fund yields just 4.8%. Again, do the math.

Now, take away the threat of a significant interest rate increase by the Federal Reserve Board (which Friday’s tame August consumer inflation report implied), and keep the realistic hope that the economy may slow but will still grow fast enough to keep corporate earnings rising, and there is arguably even less reason for people to give up their stocks.

Perhaps nowhere is that mentality stronger than among owners of many blue-chip multinational stocks, the names that make up the Dow industrial index.

Stocks like Coca-Cola, General Electric and Caterpillar have led the market back into record territory since the July sell-off. Investors obviously continue to find a lot of reasons to buy into these companies and very few reasons to sell.

Gillette decided Thursday to shell out $7 billion worth of its shares to buy battery maker Duracell, and the market applauded: Gillette stock surged $4.375 to a record $70.375 on Friday.

Coca-Cola shares are priced at 38 times analysts’ consensus 1996 earnings estimate of $1.39 a share, twice the average stock’s price-to-earnings ratio and an elevation that should start nosebleeds. But investment legend Warren Buffett still appears to be happy with his huge Coke stake, so why shouldn’t the masses be just as happy to stick with the stock?

The appeal of the blue chips is manifold: By virtue of their size, they tend to have great control over their markets and thus their destiny; they operate worldwide, which means they have many earnings-generating possibilities; and their financial power is such that they often have the wherewithal to take whatever steps (takeovers, stock buybacks, etc.) necessary to keep earnings growth on track long-term.

As Brian Rogers, manager of the blue-chip T. Rowe Price Equity Income stock fund in Baltimore notes, “Big companies are big for a reason; it’s not a matter of luck.”

But the stocks aren’t the businesses. Share prices can far overstate, or understate, a company’s potential. When does the prudent investor decide that the smart decision is, in fact, to sell rather than buy the blue chips?

Rogers says he’s making that decision all the time, because the market has been giving him the opportunity to constantly “recycle,” as he terms it: Coca-Cola may have gotten too expensive for his taste, but International Flavors & Fragrances, whose shares have been hammered by near-term earnings worries, is suddenly cheap, he says.

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Still, the fact is that many fund managers are today holding on to blue-chip stocks at price levels they might have thought expensive two years ago. Some bearish investors see a rerun of another era when the conventional wisdom was that selling these stocks was a mistake: in 1972, when the blue chips of the day rocketed to P-E ratios of 50, 60 or more as buyers begged to be let in while sellers balked.

Unfortunately, that era ended with the 1973-74 bear market, the worst market crash since the 1930s.

Is history repeating? Gordon Fines, veteran manager of the Minneapolis-based IDS New Dimensions fund, which is loaded with the classic blue chips of the 1990s, argues that even at current prices, the stocks aren’t overvalued in the context of interest rates and inflation. And P-E ratios, he notes, are still well below 1972 levels.

“I’ve found that putting a price target on stocks in a low-interest-rate environment is a difficult task,” he says. In periods like this, it’s better “to let your winners run,” he argues.

Bull market until further notice?