Specter of the Bear Looms Big

Wall Street’s bears apparently couldn’t resist adding insult to injury on Wednesday, taking another hard swipe at stocks as the worst quarter in eight years came to a dismal close.

The Dow Jones industrial average slumped 237.90 points, or 2.9%, to end at 7,842.62. That capped a quarter that saw the blue-chip index close as low as 7,539.07 on Aug. 31--a 19.3% plunge from its July 17 record high--nearly but not quite qualifying as a genuine bear market, by Wall Street’s usual bear-threshold rule of 20%.

As a further reminder of how dramatically investor sentiment shifted in the third quarter amid the most serious global financial crisis since at least 1990, the bellwether 30-year Treasury bond yield tumbled to a record low close of 4.97% on Wednesday, down from 5.09% on Tuesday and the first finish ever below 5%.

What stocks’ latest slide--and T-bonds’ spectacular rally--say loud and clear is that many investors still are terribly averse to taking on risk, and would rather shovel their money into things they perceive to be super safe.

And some market veterans say that makes good sense, even with stocks worldwide having fallen to levels which, for many individual securities, may constitute great long-term bargains.

Getting ready to write his third-quarter wrap-up for clients on Wednesday, Charles Henderson, chief investment officer at Chicago Trust Co., admitted that he was “having a hard time coming up with anything positive to say.”

Yes, the Federal Reserve Board cut interest rates on Tuesday for the first time since early-1996. Yes, individual investors, on balance, were buyers of stock mutual funds again in September, after pulling money out in August at the fastest pace since 1987.

And yes, the currency and market crises in many emerging economies worldwide seem to at least have stabilized in recent weeks.

All three of those factors helped the Dow bounce up from its lows to pare its loss for the quarter to 12.4%--leaving it down 16% from its peak.

Smaller stocks, battered mercilessly in August, have been outpacing the blue chips in recent weeks. The Russell 2,000 index of smaller stocks lost 20.5% for the quarter, and is down 26% from its peak. But at its Aug. 31 low the Russell was down 31.2% from its peak.

What continues to trouble many market pros, however, is the fundamental outlook for the economy and for corporate profits.

Current Wall Street analyst estimates have blue-chip U.S. companies’ earnings declining 2.1% this quarter from a year ago.

The profit warnings from companies have continued in a steady stream in recent weeks, as weakening economies abroad and tougher competition domestically continue to depress the earnings outlook.

What’s more, analysts have only begun to trim what many market strategists say are outrageously high earnings expectations for the fourth quarter and for 1999.

The bottom line, say many pros, is that the bottom line is in trouble. “That’s where I’m not optimistic in the short-term,” says Ned Riley, investment chief at BankBoston Corp. in Boston.

And with earnings clearly threatened, the question the market must wrestle with is how bad the situation will get, and how far off recovery may be.

Normally, of course, lower interest rates--courtesy of the Federal Reserve--would be a tonic for stocks, and would bolster the share prices investors are willing to pay relative to earnings.

But this time, many experts question whether stocks’ price-to-earnings ratios--which in the case of many blue chips, at least, still are well above historic norms--should go higher if the reason the Fed is cutting interest rates is because it fears a deflationary cycle worldwide.

Indeed, that’s what is different this time around from other bear markets, or near-bear-markets, Wall Street has suffered since 1946: It used to be high inflation investors had to fear. Now, the concern is deflation--a downward spiral of goods and services prices and asset values, rooted in too much industrial capacity worldwide and not enough buyers.

That was Gillette’s message this week, in announcing massive layoffs amid disappointing sales in many foreign countries. Gillette stock has already paid a steep price: It has plunged 39% from its 1998 peak, to $38.25 currently.

Could the broader U.S. market suffer a decline that sharp? To be sure, many of the “sacred cow” stocks that had led this long bull market remain at high levels. Microsoft, for one. Merck, for another.

The bulls insist that, bad as the third quarter was for stocks, it doesn’t signal bigger trouble ahead for the U.S. economy. The bulls see earnings improving in 1999 after a rough 1998.

But even many 1999 optimists worry that key indexes like the Dow will soon retest the lows they saw in late August, perhaps as more investors opt to recognize this year’s losses and clear the decks for the new year.

What’s more, the situation overseas remains fluid, to say the least. Tokyo stocks hit new 12-year lows overnight. Latin America still is vulnerable to a continuing wave of capital outflows. Russia is just a royal mess.

But did the third quarter itself constitute a bear market phase? The Dow, as noted, didn’t cross the 20% loss threshold on a closing basis.

For the vast majority of stocks, however, the bear has clearly arrived, not only here but in most markets worldwide.

How long he decides to stay remains to be seen.