Scaling the Wall of Worry

The stock market this year has proved again that a wall of worry is made for climbing.

The surge in share prices that continued through the third quarter has defied skeptics who said that stocks had no good reason to rebound and plenty of better reasons to stay in the dumps.

Instead, as Wall Street nears the one-year anniversary of the long bear market’s apparent demise, the bulls seem very much in control.

“This market is just chewing through people who are still negative,” said Ed Larsen, chief equity officer at AIM Capital Management Inc. in Houston.

Owners of stock mutual funds will see that in their quarterly statements: The average domestic stock fund rose 4.5% in the quarter ended Sept. 30, bringing the year-to-date average return to 18.3%, according to data firm Morningstar Inc. in Chicago.

That leaves the funds well on track to post their first calendar-year gain since 1999.

In some fund categories, the recovery has meant spectacular paper profits for investors who were smart enough, or lucky enough, to put money to work early this year.

The average fund that focuses on small-company “growth” stocks was up 28% in the first nine months. Funds that target stocks in emerging-market countries were up 31.2%. And technology funds, ravaged in the bear market, were up 37.4%, on average.

The numbers would be considered generous in any environment, but they may be more so given what stocks have faced: a formidable wall of obstacles that argued for prudent investors to stay away.

Yet one of the oldest lines on Wall Street is that the market loves to climb a wall of worry: That is, when the obstacles are well known to all, the surprise often is that the market scales them.

This year has been a classic case of exactly that, Larsen said.

The first major sign of hope this year came in March, as the approach of the war in Iraq failed to send major market indexes under the five-year lows they had reached on Oct. 9, 2002. And once the fighting began, stocks zoomed.

As the rally continued into spring, it wasn’t fazed by Federal Reserve warnings about the risks of deflation, which stirred nightmarish thoughts about the U.S. economy following Japan’s path.

Through the summer, stocks held on to their gains despite recurring fears that the economic recovery would stall out at any moment and despite rising violence against U.S. troops in Iraq.

The market’s biggest scare in the third quarter came in late September, as concerns about a continuing net loss of jobs and other soft economic data triggered a spate of profit taking.

It may not have helped that New York Atty. Gen. Eliot Spitzer last month uncovered a rash of illegal or improper “timing” trades in mutual fund shares by favored big investors -- a scandal that threatens to undermine small investors’ confidence in the fund business.

But by last week, buyers were rushing back into stocks. In a week capped by Friday’s government report that the economy added jobs in September for the first time in eight months, the blue-chip Standard & Poor’s 500 index gained 3.3% to close at 1,029.85. That left it less than 1% below the 15-month closing high set on Sept. 18.

Measured from its five-year closing low of 776.76 set on Oct. 9 of last year, the S&P; index has soared 32.5%. The Nasdaq composite index, dominated by technology stocks, has rocketed nearly 69% in the same period.

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Pros Are Reluctant to Call It a Bull Market

Yet many market veterans aren’t sure what to call this rebound. Historically, after a deep slide in share prices a rise of 20% to 25% in major indexes over an extended period has qualified as a new bull market.

This time, many pros are reluctant to sound too comforted by stocks’ performance. Given the devastation wrought by the three-year bear market, there still is a lot of talk that this rally could be a flash in the pan.

One of the biggest doubters on Wall Street is Richard Bernstein, chief U.S. market strategist for Merrill Lynch & Co. in New York. He believes that most investors, whether they admit it or not, have high expectations for stock returns over the next few years.

That is a sure setup for disappointment, Bernstein said. “High expected returns are rarely forecasted for the asset class that ultimately outperforms,” he said. Investors, he added, still haven’t shaken the strongly bullish long-term view of stocks that defined the late 1990s.

That isn’t how Ned Riley sees it. The chief investment strategist at State Street Global Advisors in Boston points to a dramatic shift in Wall Street analysts’ recommendations since the bull market peaked in early 2000.

In January 2000, 71.2% of stock recommendations were “buy” or “strong buy,” according to data firm Thomson First Call. The remaining 28.8% were either “hold” or “sell” recommendations.

As of last week, “buys” and “strong buys” accounted for 42.8% of the total 24,441 brokerage recommendations tracked by Thomson First Call. Not only was that far below the January 2000 total, but it also was below the 44.9% share held by “buys” and “strong buys” at the end of March of this year.

In other words, as the market has risen over the last six months, analysts have become less bullish, not more so.

Riley asserts that many investors who have missed the turnaround now are “entrenched in their positions” as skeptics -- in the same way that the multitude of optimistic investors in 1999 were entrenched, expecting stocks’ gains to continue forever, he said.

“These are all people who didn’t turn when they should have,” he said.

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Tiptoeing Around the Tech Resurrection

One aspect of the market’s advance this year that has troubled bulls and bears alike is that the most speculative stocks, especially in the technology sector, have scored the biggest percentage gains.

With major tech stock indexes up 70% or more, “Nobody’s willing to say that’s a good thing,” said James Paulsen, chief investment strategist at Wells Capital Management in Minneapolis.

But Paulsen doesn’t see a problem in the resurgence of beaten-down stocks.

“That happens at the end of every recession,” he said. A stock that drops, from, say, $50 to $2, and then rebounds to $8, looks like a huge winner. Yet in fact, “the market is just taking the bankruptcy risk out of these shares,” Paulsen said. “And it doesn’t take a lot of dollars to cause these stocks to bloom.”

The snap-back in the most downtrodden stocks is distracting from the impressive breadth of this year’s rally, Wall Street bulls say. Nearly every stock mutual fund category has racked up a double-digit gain, according to Morningstar.

Technology-sector funds have led the pack with their 37.4% average gain in the first nine months. But other fund categories up more than 20% included precious-metals funds, Japanese-stock funds, real estate-oriented funds and portfolios that focus on small-company “value” shares.

Yet among AIM Capital Management’s mutual fund managers, Ed Larsen said he doesn’t detect much bravado.

“I don’t have anyone who’s euphoric,” he said. “There are very few people walking around with their chests out.”

One explanation for that: Despite their gains, most stock funds are lagging behind their primary benchmark indexes this year.

For example, just 38.2% of funds that focus on large-company stocks beat the 14.7% advance in the S&P; 500 index in the first nine months, according to Morningstar.

Among small-company-stock funds, fewer than one-third beat the Russell 2,000 small-stock index’s 28.6% gain.

Dan McNeela, an analyst at Morningstar, said most funds are behind their benchmarks because fund managers were unwilling or unable to take a chance on the riskiest stocks, which have rallied the most this year.

With three months left in the year, the funds’ index-trailing performance raises the stakes for portfolio managers, some experts say. At the very least, if the market rally continues, it could force many managers to go with the flow to avoid falling further behind.

But market bulls say it’s fundamentals, not sheer “momentum,” that should keep stocks moving higher.

For one, the Federal Reserve has openly pledged to keep pumping money into the economy. The central bank’s key short-term interest rate is at a 45-year low of 1%, and many economists believe it could stay there until spring, at a minimum.

“When the Fed creates liquidity, there are only two places for it to go: financial assets or real assets,” Larsen said.

Also supporting share prices is the continuing recovery in corporate earnings. Thomson First Call says analysts now expect operating earnings (profit before one-time gains or losses) for the S&P; 500 companies overall to rise 15.9% in the third quarter from a year earlier, and 21.8% in the fourth quarter.

Earnings growth is expected to slow in the first half of next year to 12% to 13%. Still, a rising bottom line could assuage some investors’ worries about stock valuations. The S&P; 500 now is priced between 18 and 21 times this year’s estimated operating profit, which isn’t cheap historically.

“But you’ve got the whole global economic expansion ahead of you,” Riley said.

Indeed, some market pros say the argument for sticking with stocks is simple when boiled down: If the economy continues to expand, long-term bond yields probably will continue to rise (as they have since mid-June), which means the outlook “is pretty ugly for bonds, but favorable for stocks,” said Jack Ablin, chief investment officer at Harris Trust & Savings Bank in Chicago.

For stock mutual fund investors who are inclined to stay optimistic, one key question is whether the biggest sector winners of the last nine months will continue to lead, or whether they will be supplanted by other sectors.

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Large-Cap Stocks Could Move to the Fore

Wells Capital’s Paulsen believes that bigger stocks probably will take the lead away from smaller stocks, helped in part by the weakening dollar, which should be good news for multinational companies by making their products less expensive for foreign buyers.

Ablin agrees: “I think there will be a reversal of roles, to large cap outperforming small cap and higher quality beating lower quality,” he said.

But he also believes that emerging-market stocks could continue to score hefty gains if the global economy accelerates.

Of course, if mutual fund investors have learned anything over the last five years, it’s that the best strategy is to be well diversified rather than to bet heavily on one or two fund sectors.

If a major lesson of the last few years also was that stock investors should guard against becoming too greedy, the danger now is that many investors who need decent growth in their portfolios could be too cautious, if the economy is in fact on a sustained recovery track, Wall Street bulls say.

The obstacles in front of the market remain substantial. The Iraq situation could worsen; high energy prices could persist; terrorism is an ever-present threat; and the economy could still falter, leading to deflation.

So far, however, the market has dealt with the wall of worry in classic fashion -- by scaling it rather than running from it.