It’s Worse Than You Think, and That May Be Good

A few things we’ve learned to expect from Wall Street in the 1990s:

* With respect to the economic news, bad is good, and good is bad.

* A stock in favor can remain so for a long time. A stock out of favor can remain so for equally as long, or longer.

* The market’s forgiveness can usually be purchased only at great expense.

Why recite these lessons now? They explain a lot of what is going on in financial markets--and why few investors are having much fun these days.

Friday brought more of the same: Stocks closed broadly lower as bond yields surged in the wake of fresh data suggesting the U.S. economy is still on fire.

The Dow industrials ended at 10,273.00, down 0.6% for the day, 0.1% for the week and 9.3% from their record high set Aug. 25.

With Federal Reserve policymakers meeting Tuesday, the risks now seem to have increased that the central bank will do what it did in June and again in August: raise short-term interest rates to try to slow the economy.

That would be bad for the bond market, of course. And even novice investors know that when interest rates are rising, the stock market at best gets indigestion--and at worse gets a very serious flu.

Yet it must still be quite difficult for many investors to accept the 1990s’ great “disconnect” between the economy’s trends and stocks’ fortunes. The market has seemed to like it best when business is bad; when things are looking up for the economy, Wall Street almost can’t stand it.

Last week, Dun & Bradstreet released results of a survey of 3,000 U.S. business executives. The majority were exceedingly optimistic about the fourth quarter, with most predicting strong sales, rising exports, higher earnings and more hiring. Yet few expected this improvement in business to lead to higher prices or more inflation.

Third-quarter corporate earnings, meanwhile, are expected to rise nearly 20% from a year ago, on average, for the blue-chip Standard & Poor’s 500 companies, according to earnings tracker First Call.

A reasonable person might ask, “So what if the Fed raises interest rates another quarter-point?” That would only lift its benchmark short-term rate back to 5.5%, which is where it was in the summer of 1998--when the business outlook worldwide was deteriorating instead of getting better.

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But the global economic recovery we’re now enjoying (as workers, if not as investors) creates more potential problems for financial markets than simply higher interest rates, argues Stephen Roach, economist at Morgan Stanley Dean Witter.

In a recent report titled “The Irony of Global Healing,” Roach says that “on the surface, global healing certainly seems to have made the world economy a safer place. An increasingly vigorous recovery in world activity has come as welcome relief in the aftermath of the worst financial crisis in half a century”--a reference to the Russian debt default a year ago and the subsequent seizing-up of markets.

But he also notes that “healing changes the game for global policymakers” such as central banks. “In the depths of crisis, the drill was straightforward. Policies were aimed at saving the world. Aggressive monetary accommodation [i.e., lower interest rates] quickly became a no-brainer.”

Now, with recovery in swing, policymakers must “rejoin the timeworn debate over the business cycle,” Roach says. To wit: How great is the inflation risk if the economy booms? How high should interest rates be raised to restrain growth without shutting it down?

What’s more, he notes, there are peculiar risks for the United States as the rest of the world finally enjoys better times.

Although the focus on the “weak dollar” over the last few months is perhaps overstated--the dollar has lost 13% of its value against the Japanese yen since June 30 but just 4% of its value versus the euro--the trend tells you that global investors are finding other things to do with their capital than invest in dollar-denominated assets.

Why should we care? Because a weak dollar poses certain challenges for the U.S. economy. Among the biggest: potentially higher prices for imported goods (and we know Americans love imports) and a possible decline in foreign investment in our stocks and bonds if foreigners fear their holdings will be devalued with the dollar.

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But is all of this really what has been guiding investors who have either dumped stocks in recent months or simply stepped away from the market, producing the broad pullback that Wall Street gently refers to as a “correction”? Should we blame Y2K computer bug worries instead? Rising oil prices? The Taiwan earthquake?

It could be that the market is sinking under the weight of all of the above. A continuing stream of bad news can wear down even the sunniest optimist, after all. Stock prices are all about confidence. How much do you have?

What we know for sure is that stocks overall are in worse shape than the Dow would suggest.

New data Friday from brokerage Salomon Smith Barney show just how deep and widespread the market’s decline has become:

* The average New York Stock Exchange stock has fallen 27.7% from its 52-week high (through last Tuesday), or nearly three times the Dow’s decline from its high.

* The average Nasdaq stock is down a stunning 34.8% from its 52-week high.

Because averages can be skewed by some very big losers (or winners), Salomon Smith Barney looked at the market from another angle: the percentage of issues traded that have fallen more than 10%, 20% or 30%.

On the NYSE, 37.5% of all stocks now are down 30% or more from their 52-week highs. And 62.6% are down 20% or more.

On Nasdaq, 52.1% of all stocks traded now have lost 30% or more from their highs, and a whopping 70.9% are down at least 20%.

Perhaps most striking is that the hammering has become relentless in the cases of many former market stars. Example: Mattel on Friday plunged $2.13 to $16.88, its lowest price since 1995, amid fears that the company’s earnings may again miss expectations.

Many health-maintenance organization stocks dived 20% or more Thursday on reports that the industry may be hit with class-action suits alleging lousy patient care.

The term “out of favor” is quickly becoming superfluous in trying to segment stock groups. With few exceptions--notably, the new-issues market, where the speculators still are running wild--try to name some stock groups that are in favor.

How much worse can it get? That’s the trillion-dollar question, of course. To buy into the market today takes a lot of guts, with the interest rate question looming and Y2K worries likely to become more pronounced in coming months.

But then, buying stocks when they’re down is always the hardest decision. It’s also the way savvy investors reap the biggest rewards in the long run.

A year ago, at the depths of the market’s fears about the world economy, few people wanted to sink money into Asian stocks. One year later the average Japanese stock mutual fund is up 100%.

Wall Street’s bears argue that even though U.S. stock prices are down, they aren’t down enough. The pain level needs to become excruciating, they say, before stocks will be worth buying.

It could happen, certainly. But if the outlook for interest rates, inflation, the dollar, corporate earnings and other key market concerns isn’t as dire as many people now fear, there is at least a reasonable chance that what is now a bad bear market for many stocks won’t turn into a severe one--and instead will give way to another substantial rally sooner than later.

The accompanying graphic is something I’ve kept on the wall next to my desk for decades--I received it so many years ago I’ve forgotten its source.

It tells the story of the market’s cycle: At the bottom of the curve (when stock prices are depressed) investors view shares with contempt. As the market rallies, investors first are cautious, then confident. At or near the peak, investors have total conviction about their stocks, and even when prices begin to fall, psychology remains complacent (“It’ll blow over”).

Finally, when prices are down sharply, there is concern. As they fall further, concern turns to capitulation (“Get me out at any price!”). Which then leads to contempt--and the cycle starts over.

Where are we now on the bell curve? With many stocks, I’d argue we’re already into concern and capitulation. The bears say we’ve only crested conviction.

Someone’s going to be wrong.

Tom Petruno can be reached at tom.petruno@latimes.com.