September Ushers In a Season of Investor Worry

April may have been T.S. Eliot’s idea of the cruelest month, but for Wall Street no month has been more consistently cruel than September.

And this September, there is far more than just the turn of the calendar page worrying many investors.

With Southeast Asian stock markets and currencies in meltdown mode, U.S. blue-chip stocks bouncing wildly in recent weeks, and selling having accelerated in August in previously high-flying world stock markets, investors have good reason to fear that September will bring trouble.

The issue is not so much the sudden volatility in stock markets, but the question of what is causing that volatility. Is it just a matter of long-overdue profit-taking--or a warning that the favorable fundamentals that have fueled stocks’ advance worldwide in the 1990s are rapidly dissipating?

In Southeast Asia, of course, there is little doubt that the fundamentals have dramatically changed for the worse, at least in the near term. The plunge in currency values throughout the region has sent interest rates soaring and dimmed prospects for corporate earnings and economic growth for this year, and possibly even for the first half of 1998.

Investors continue to flee Southeast Asian stocks, even though many of those markets have already plunged between 20% and 43% from their 1997 peaks in local currency terms. (They’re off even more in dollar terms, given currency devaluations.)

The collapse of share prices in Southeast Asia is a chilling reminder of what can happen when investor psychology turns from greed to fear.

But is there any reason to believe that the U.S. bull market is in similar danger after its tremendous run of nearly seven years?

Many analysts say no. The 7.7% drop in the Dow Jones industrials, to 7,622.42 by Friday from the Aug. 6 peak of 8,259.31, is “just a consolidation, 1997-style,” argues Eugene Peroni, veteran technical analyst at brokerage Janney Montgomery Scott in Philadelphia.

Like the Dow’s spring decline, which shaved nearly 10% from the index, this one has been “abrupt and sharp,” Peroni notes, and the volatility accompanying it has understandably scared some investors. But that’s healthy in a bull market, he says.

“I think the volatility is starting to weed out some of the weak hands” from the market, Peroni says. In other words, stock is being sold to “stronger hands,” meaning investors who are more likely to stay put, he says.

Like other market technicians, Peroni has been heartened by gains in smaller stocks, even as blue-chip shares have slumped. The Russell 2,000 index of smaller stocks hit a record high Friday, rising 0.4% to 423.43, even as the Dow fell 1%.

What’s more, Peroni believes U.S. investor psychology still is largely positive toward stocks, which he expects will limit any market “correction.”

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Other analysts, however, are much more worried about the possible message in the Dow’s slide, given the background noise: the market carnage in Southeast Asia, growing concern about an increase in German interest rates this fall, and the recent profit warnings from such market leaders as Coca-Cola and Gillette.

David Shulman, investment strategist at brokerage Salomon Bros. in New York, concedes that it isn’t clear whether the fundamentals supporting the U.S. bull market are indeed falling away.

But if that’s the case, he says, it should become far more apparent in coming weeks. For now, he says, the stock market remains a battleground for two camps: those who believe in the “new paradigm” U.S. economy, wherein economic growth remains steady while inflation and interest rates remain low, and those who fear that we are in the midst of “some variant of the normal cyclical economy,” which will soon give way to either overheating and higher inflation or a distinct cooling and a sharp decline in corporate earnings.

Either way, if the economy is about to take a sharp cyclical turn, Shulman argues that “stocks are extraordinarily overvalued.”

For investors who are in that camp, the calendar can’t offer much solace. Since 1950, September has hands-down been the month least kind to the bulls.

Between 1950 and 1990, the Dow industrials fell in 27 Septembers and rose in 14, a bearish tilt unrivaled by any other month, according to the Stock Trader’s Almanac.

Since 1990, however, September has been less trying for stocks, with the Dow rising in three Septembers and falling in three.

And this time around? As investors mull whether and what to buy and sell this fall, here are the issues that should frame the debate and the choices:

* Southeast Asian woes: More detriment than benefit, or vice versa? There is no doubt in the minds of most economists that what has happened thus far in Southeast Asia is a negative for world economic growth in the near term. The one region of the world where decent growth was considered a “sure thing” now has question marks all over it.

Naturally, that could mean weaker sales and earnings for many U.S. firms that export to the region.

The potential benefit to U.S. markets, however, is that the turmoil in Asia and its effect on world economic growth could keep interest rates down, benefiting stocks.

What’s more, global investors’ growing fear about Asian stocks in general--both in terms of price risk and currency risk--could bring money back to U.S. stocks and bonds in the near term.

“The weakness there will just benefit our markets,” Peroni argues.

In fact, that’s what happened in 1995 in the wake of the Mexican peso devaluation: Many global investors saw the United States as a safe haven.

And what about battered Asian markets--is it time to start buying? Yes, if you have a three-year time horizon, some analysts say. But in the near term, note that Asian markets haven’t yet matched the 45% decline that Mexican stocks experienced in local currency terms in 1994-95, once the peso devaluation was underway.

History doesn’t necessarily repeat, but it often rhymes.

* U.S. corporate earnings: Is a shift in leadership underway? Southeast Asia’s troubles could magnify what has already been a difficult summer for many U.S. multinational companies, at least as regards their ability to meet earnings growth targets.

The dollar’s strength worldwide, including in Europe (until the last few weeks), may have dampened export growth for some U.S. companies. At the very least, the strong dollar means foreign profits are worth less when repatriated. That raises the risk that Coke and Gillette were just the vanguards of a wave of earnings-shortfall warnings.

That may be what the declines in the Dow and in the Standard & Poor’s 500 index in recent weeks are foreshadowing.

In the meantime, the strength in smaller stocks may be reflecting optimism about smaller companies’ earnings growth.

Because smaller companies’ fortunes are tied more to the domestic economy’s strength, it could be that year-over-year earnings growth of those companies will look much better this quarter than earnings growth of many blue chips--which in recent years have been prized for their reliable growth.

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In fact, Boston-based First Call, which tracks corporate earnings, says a shift in earnings growth leadership may already be underway: Profits of the Russell 2,000 companies rose 13.4% overall in the second quarter from a year earlier, compared with a 10.5% gain in earnings for the S&P; 500 companies.

What’s more, in the current quarter, Russell 2,000 companies’ year-over-year earnings growth now is estimated at 29%, versus 12.3% for the S&P; 500 companies, according to First Call’s tally of Wall Street analysts’ expectations.

That wide gulf in expected profit growth also holds for the fourth quarter, First Call says, even though the firm’s research chief, Chuck Hill, cautions that estimates for smaller companies will probably decline more in coming weeks than estimates for blue-chip firms, as analysts fine-tune their figures.

Still, says Hill, “this looks like more of a consistent pattern” in terms of small-company earnings overall outpacing bigger companies’ growth. And that could mean that even if blue-chip stocks continue to be sold off in coming weeks, smaller stocks--which on balance are selling for much lower price-to-earnings ratios than big blue chips--will remain strong, and perhaps even continue to advance.

Analysts also caution, however, that if blue-chip stocks are on the verge of a deep decline--a genuine bear market, which would shave 20% or more from the Dow--it will only be a matter of time before smaller stocks also succumb.

* Interest rates: Will central banks hold tight? In light of the two other big fundamental concerns dogging stocks now--worries about future global economic growth and about corporate earnings--the one thing the market definitely doesn’t need is higher interest rates.

Yet the German Bundesbank has been raising that possibility in recent weeks, because the dollar’s surge this year versus the German mark is boosting German inflation by raising the cost of imports.

If the Bundesbank tightens credit in September, the shock waves would be felt across Europe. Then the question would be: What does the U.S. Federal Reserve do?

If you believe that the Fed could be compelled to raise rates soon if it sees more signs of robust U.S. growth and any hint of higher inflation, any other reasons for buying stocks near-term could be moot.

Remember that in March, it took just a quarter-point boost in the Fed’s key short-term interest rate to send the Dow down nearly 10%--and that was at a point where the Dow was at 7,100--or 522 points below its current level.

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Is the Blue-Chip/Small Stock Split ...

While blue-chip stocks, as represented by the Standard & Poor’s 500 index, have sunk in recent weeks, smaller stocks, as represented by the Russell 2,000 index, have moved up to record highs. Weekly closes since May 16:

S&P; 500 index

Friday: 899.47

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Russell 2,000 index

Friday: 423.43

Total earnings of the companies in the Russell 2,000 index rose faster than those of the blue-chip S&P; 500 companies in the second quarter--a trend expected to be even more pronounced in the third and fourth quarters. Actual and estimated year-over-year earnings gains:

S&P; 500 Russell 2,000

4th quarter*

S&P; 500: 13.5%

Russell 2,000: 36.0%

* Estimate

The Damage So Far

Led by Southeast Asian markets, most major world stock indexes are already well off from their 1997 peaks. But most are still up sharply year-to-date.

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Latest Pctg. change from: Market/index close ’97 peak Jan. 1 North America U.S./Nasdaq composite 1,587.32 -2.6% +23.0% Canada/TSE 300 6,611.79 -5.1 +11.6 U.S./S&P; 500 899.47 -6.3 +21.4 U.S./Dow industrials 7,622.42 -7.7 +18.2 Mexico/Bolsa 4,648.41 -11.8 +38.3 South America Argentina/Merval 810.05 -6.9% +24.7% Brazil/Bovespa 10,109.00 -27.8 +43.6 Europe Britain/FTSE-100 4,870.20 -4.3% +18.3% Italy/MIB-30 21,596.00 -6.5 +37.6 Spain/IBEX-35 6,599.10 -8.4 +28.0 France/CAC-40 2,805.84 -9.7 +21.2 Germany/DAX-30 3,989.96 -10.5 +38.1 Asia Australia/All Ordin. 2,590.80 -6.1% +6.9% Korea/composite 682.20 -13.9 +4.8 Japan/Nikkei-225 17,974.30 -14.0 -7.2 Hong Kong/Hang Seng 13,425.65 -20.2 -0.2 Singapore/Strait Times 1,786.44 -21.6 -19.4 Indonesia/composite 485.97 -34.6 -23.8 Malaysia/composite 804.40 -37.1 -35.0 Philippines/composite 1,975.28 -42.7 -37.7 Thailand/SET 493.84 -43.3 -40.6

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Source: Bloomberg News