Over the Valley: Stocks’ Long-Term Trend Will Hinge on Many Factors

The “bubble” stock market still is deflating, but with every new decline share prices get closer to their final lows of this bear market, the worst in at least 13 years.

And then what?

Many investors would, of course, love to see stocks suddenly rocket for the moon again. That has happened before: When the bear markets of 1973-74, 1981-82 and 1990-91 finally ended, the blue-chip Standard & Poor’s 500 index was up 25%, 37% and 25%, respectively, just four months later.

But bear markets tend to be messy affairs, and likewise their aftermath. Stocks don’t bounce back uniformly. Some don’t bounce back at all.

With the first quarter now history, and the gloom still thick on Wall Street as the S&P; remains down 24% from its 2000 peak while the Nasdaq composite is down 64% from its high, many investors may be growing tired of tallying their losses from the yearlong market slide.

Since you can’t fix what is past, it’s more relevant and more interesting to focus your energy on what might happen next. If you start to do that with stocks, it becomes clear in a hurry that many factors will shape the market’s next phase.

The economy’s trend is paramount, naturally. If a full-blown recession looms, investors’ concerns about already dwindling corporate earnings may be magnified many times over, and stock prices could face much more devastation. That is the greatest risk still facing this market, and no one should underestimate it.

But even if Wall Street’s bulls are correct, and the economy begins to perk up by midyear, or by fall at the latest, that might not be enough to fuel a broad-based, dramatic turnaround in corporate earnings or in share prices.

One unpleasant but entirely reasonable thesis about the next few years is that they could be, in some key ways, a mirror image of the 1990s.

In the last decade everything that happened in the world economy seemed to be to the benefit of the U.S. economy, often at the expense of others.

The fall of the Soviet Union and China’s capitalist shift played directly into America’s hands. So did currency devaluations in Mexico (in 1994) and then in East Asia (starting in 1997), which made their exports cheaper for U.S. buyers and also helped send global oil prices crashing. Those were big factors in keeping inflation a no-show.

Overall, with opportunities elsewhere viewed as limited, foreign investors were happy to invest in the United States, bolstering the dollar, financing the huge U.S. trade deficit and adding to strong domestic demand for stocks.

Meanwhile, on the international political front, peace seemed to be breaking out all over, boosting confidence in the future.

Perhaps most important for the U.S. economy, the rise of the Internet spawned an explosion of investment in technology and the sense that a “new economy”--and a virtually invincible one--had been born.

Add it up, and the 1990s were unquestionably a very lucky time for the United States. And the stock market responded accordingly--with a spectacular bull market that pushed share prices to historically high levels relative to underlying earnings.

*

Now, investors look around and see reversals of many of the 1990s’ gains. The Mideast situation appears dismal. Some version of the Cold War may be back on between the United States and Russia. Japan’s economy may be back in recession. Energy prices have rocketed. And the vaunted new economy is in tatters as tech spending has proved as cyclical as most other kinds of spending.

The new millennium isn’t looking quite so lucky for the United States as the last sliver of the old millennium. No wonder investors are taking a much more sober view of stock prices. When you buy a stock, after all, you’re buying a claim on the future success of that company in particular and the economy in general.

Fundamentally, investors’ central concern is (or should be) how all of this affects corporate earnings. Because of the sheer number of companies that have warned this quarter about a deteriorating bottom line, some recent Wall Street optimists have changed their tune.

Edward Yardeni, economist at Deutsche Bank Securities and a relative bull earlier this year, said he has found the trend in earnings news “disturbing.” The first quarter may even be worse than advertised, he said, and the second quarter is likely to bring bad news as well as companies cope with “weak sales, weak productivity, weak pricing and a weak euro.”

What’s more, “businesses in the world’s sixth-largest economy--California--are about to get their profits squeezed by a sharp increase in electric rates,” he noted.

Still, at some point stock prices will reflect all or most of the poor near-term earnings outlook. Investors will begin to look over the valley, as it were. That’s where the bear market will end.

The stock price bubble of the late 1990s and early 2000 represented investors’ valuation of shares for a perfect world--one that no longer exists. The bubble is deflating, and though we can’t know exactly how far along it is in the process, we know that many stocks now are bigger potential bargains than they were three months ago or 12 months ago.

That’s the good news, and it’s worth keeping in mind amid the deep gloom of Wall Street these days. This too shall pass.

But whether this bear market will give way to a rousing new bull market--or just a modest and slow recovery in stock prices--may hinge on how positively or negatively investors view the broader backdrop for the economy and investing in this decade.

*

Assuming the data in the next few months strengthen the idea that we aren’t in a genuine recession, investors’ focus will shift to looking for signs of a turnaround--and to looking for possible obstacles to a turnaround.

Here are some of the things Wall Street pros will be watching closely:

* Can tech sector orders stabilize soon? The first quarter is looking like a disaster for many tech companies, as customers delay or cancel orders. Many tech giants, such as Cisco Systems, say they have little sense of when orders will begin to pick up again.

Yet Federal Reserve officials in recent weeks have insisted that the economy is in fact working off excess inventories built up last year in technology and elsewhere.

In the second quarter, any sign that order rates for tech equipment have at least stabilized could be critical in stopping the hemorrhaging in the stocks. One announcement from a major tech firm may not do it, but a succession of such announcements could.

* Will inflation stay down? The stock market would probably be a lot lower today if the Federal Reserve hadn’t cut interest rates three times this year. The Fed is on the market’s side now, even if investors so far aren’t putting much faith in the central bank’s efforts to reinvigorate the economy.

But further Fed rate cuts will depend in large part on the inflation outlook. A popular bear case against stocks is that the economy, despite its slowdown, will suffer higher inflation this year because of energy prices, upward pressure on medical costs and more companies’ attempts to raise prices to offset lower sales volume.

Bad surprises this spring in the government’s wholesale and/or consumer inflation indexes could trigger a vicious response on Wall Street, on the assumption that the Fed would become hamstrung in its efforts to ease credit.

* Will the dollar’s value hold up? The dollar remains the currency of choice worldwide. A strong dollar hurts U.S. companies in terms of exports and in terms of competing with cheaper imports. But many economists say that, given the nation’s still-heavy reliance on foreign capital, a decline in the dollar could wreak worse havoc by driving foreigners away from U.S. assets.

All other things being equal, many Wall Street pros would prefer not to have a weak dollar to worry about.

* Can the financial system avoid a major bomb? Companies and consumers took on heavy debts in the 1990s. So far, the financial system has coped with rising delinquency rates on loans and bonds. But in a weak economy, the risk rises that some major financial institution could incur surprising losses that could push it toward insolvency--triggering a domino effect within the banking system.

Investors have heard this concern before, of course. They should hope that it remains only a worry and not a reality.

*

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