Stock Market Rally Gains Believers -- and Skeptics

As the stock market continues its steady ascent, its ranks of believers seem to be swelling.

Historically, that’s often what happens as a rally is ending. But this spring’s advance is so broad that many analysts are afraid to call it quits just yet.

Last week, the blue-chip Standard & Poor’s 500 index and the technology-dominated Nasdaq composite index both scored their fifth straight winning weeks.

The market has surged despite flimsy -- if any -- evidence of a stronger economy. Some reports last week suggested that the economy is getting weaker.

On Friday, Treasury bond yields hit new generational lows on concerns that soft business and consumer spending is leaving the economy vulnerable to full-fledged deflation, or a widespread decline in prices. That could be devastating for corporate pricing power and earnings.

Yet major stock indexes eased just modestly Friday. The Dow Jones industrial average slipped 34.17 points, or 0.4%, to 8,678.97. It’s up 15.3% since March 11. The Nasdaq index, at 1,538.53 on Friday, is up 21% in the same period.

“I’m calling it the ‘Teflon market’ because nothing really sticks in terms of bad news,” said Kevin Marder, chief market strategist at Ladenburg Thalmann Asset Management in Los Angeles.

In some ways, the rally is reminiscent of the market’s glory days of 1999. Technology stocks, especially Internet names, are leading the way. EBay Inc., Amazon.com Inc. and Yahoo Inc. all hit 52-week highs Friday.

Why isn’t Wall Street more cautious -- especially with the Federal Reserve warning about deflation?

Some bullish investors who drove stocks higher starting in mid-March, betting that the war in Iraq would be over quickly, may figure they’ll be right again in betting that the economy will in fact stage a rebound in the second half.

“The market seems to be pricing in a better economy and better corporate earnings over the next six to nine months. That’s the market’s job, to look ahead,” Marder said.

As for interest rates, it may be tough for investors to see anything but good news, for now, in rates’ ongoing decline, analysts say.

With Treasury bond and money market yields so low, stocks will look relatively attractive even if they post modest single-digit gains from current levels, said Sung Won Sohn, chief economist at Wells Fargo & Co. in Minneapolis.

Though he is wary of the market, Sohn said investors have concluded from the Fed’s statements that it is likely to cut interest rates again soon and that, as the year progresses, the Fed will give any economic recovery a running start before it will think about raising rates.

The equity market knows it “does not have to fear tighter monetary policy anytime soon,” Sohn said.

The rally also may be gaining support as investors who have stayed away for a long period, perhaps for years, decide that it’s finally time to get back in, after the worst bear market since the 1930s.

Encouraged by higher share prices and the end of the Iraq war, small investors are returning to stock mutual funds, for example. Investors poured a net $14 billion into equity funds in April, according to an estimate Friday by fund tracker Lipper Inc. in Denver. If confirmed by official industry data, that would be the biggest net inflow since April 2002.

Perhaps more important, institutional investors continue to show confidence in stocks, Marder said. Volume has generally been heavy on days the market has risen, he said, a sign that big investors such as pension funds are buying blocks of stock.

The rally’s consistency also has impressed analysts. The S&P; 500 has risen eight of the last 10 weeks.

“This market is like a beach ball you try to push underwater. It just keeps bouncing back,” said Steve Todd, editor of the Todd Market Forecast newsletter in Mission Viejo.

Breadth is another encouraging element of the “orderly advance,” as Todd calls it: Advancing stocks have outnumbered losers by healthy ratios of 2 to 1 or 3 to 1 in many recent trading sessions. Within the S&P; 500, 90 stock industry sectors have advanced over the last month; just 11 have lost ground.

Even so, there are many reasons to be skeptical, or at least cautious, about the rally, experts acknowledge.

Along with a shaky U.S. economy, geopolitical events could threaten investors’ confidence. The Iraq war may be over, but last week’s terrorist attacks in Saudi Arabia and Morocco were a reminder of the risks still present.

Also, many stocks already are highly valued relative to potential 2003 and 2004 earnings, analysts warn.

As investor confidence increases, that, too, becomes a problem.

Analysts generally prefer to see investor sentiment indexes show more fear, not less, because the theory is that the market “climbs a wall of worry.” When fear is low there may not be enough pent-up demand to drive prices higher, contrarians say.

The VIX index, which gauges investor caution by measuring hedging activity in the options market, is at its lowest point in a year. The percentage of bearish newsletter editors in Investors Intelligence’s weekly survey has reached its lowest level since January 2002.

“It’s a little disconcerting,” Marder said. “There appears to be too much complacency, at least for my blood.”

The strong performance by tech stocks also raises some eyebrows.

“It feels like people are trying to chase performance, buying things that are working,” said Jack Caffrey, equity strategist at J.P. Morgan Private Bank. “That’s a self-perpetuating cycle, but it also can be dangerous. It’s like a game of musical chairs: When the music stops, the last buyer is left holding the bag.”

Caffrey said he would like to add to his equity holdings but is waiting for a pullback, figuring that a drop in prices would offer a degree of safety.

Even bulls acknowledge that the market could be due for a breather.

“The market is overbought, and it would not be a shock to see a bit of a decline within an ongoing bull market,” Todd said. “It’s just that right now, it doesn’t even want to do that.”

Todd said the rally reminds him of 1991, when stocks marched ahead while many supposed experts fretted about the economy.

“The stock market doesn’t follow the economy, the economy follows the stock market,” he said. “The Dow made a new all-time high on March 1, 1991, and still people were talking about whether there would be a ‘double-dip’ recession.”

The Dow finished 1991 with a 20.3% rise, then posted gains for the next eight years.

“I have a rule: Never listen to an economist,” Todd said.