Stock Rally May Be Tested This Month

While much of the country was vacationing, the stock market’s bulls had some work to do in August to keep the 2003 rally alive.

They succeeded: As September begins, major market indexes are either at or very near their highest levels in more than a year -- adding heft to the argument that the surge in share prices since mid-March is no flash in the pan.

At this point on the calendar in 2001 and 2002, most investors were staring at severe year-to-date losses in their stock portfolios as the long bear market dragged on.

This year, the average U.S. stock mutual fund is boasting a 19.6% gain through Friday, according to fund tracker Morningstar Inc. in Chicago.

The rally that began March 12 was fueled initially by expectations that the war in Iraq would be over quickly. But in recent months the main market driver has been a barrage of increasingly upbeat economic data.

If the business outlook is improving, then corporate earnings are likely to continue rising, underpinning equity values, optimists say. It’s a cause-and- effect relationship as old as the stock market itself, they say.

Robert Bissell, chief investment officer at Wells Capital Management in Los Angeles, said he viewed the rally since March as just the first step in the market’s recovery from the worst decline in a generation.

The next step, he said, should be that as corporate sales rise with the economy, “it all drops to the bottom line” for many companies, providing the foundation for another move up in stocks.

Indeed, Wall Street analysts’ consensus estimates call for operating earnings of the blue-chip Standard & Poor’s 500 companies to rise 14.5% in the current quarter, year over year, and 21.2% in the fourth quarter, after a 9.6% rise in the second quarter, according to earnings tracker Thomson First Call in Boston.

But those numbers don’t thrill some money managers, who worry that prices of most stocks already reflect a sharp improvement in corporate profit.

The price-to-earnings ratio of the S&P; 500 is about 19 based on estimated operating earnings for this year, Thomson First Call says. The P/E is higher if net income -- after “one-time” write-offs -- is used. Either way, blue-chip stock valuations are fair at best and expensive at worst, many market veterans say.

“Right now, you don’t have a lot of stocks with compelling valuations -- the kind that get us excited,” said Jon Bosse, chief investment officer at NWQ Investment Management in L.A. and manager of the Nuveen/NWQ Multi-Cap Value fund.

Some analysts also worry that there was less to stocks’ August rally than met the eye. Though key indexes -- including the broad Wilshire 5,000, the technology-dominated Nasdaq composite and the Russell 2,000 small-stock index -- on Friday were at their highest levels in at least 14 months, trading was typically thin in August.

At the same time, there have been some classic warning signs that share prices are reaching at least a near-term peak. For example, investor-sentiment surveys show the complacency level is high, while corporate insiders have been heavy sellers of their companies’ shares.

Mark Keller, investment strategist at brokerage A.G. Edwards & Sons in St. Louis, believes the market essentially has been in “correction mode” for the last 2 1/2 months, after soaring from mid-March to mid-June.

The sideways pattern still could give way to a decline, he said, as the market enters September -- which historically has been Wall Street’s weakest month of the year.

There are fundamental and psychological reasons September often has been a poor month for stocks.

The supply of stock can outstrip demand as Wall Street pros return from vacation and the calendar of new share offerings usually ramps up.

Meanwhile, mutual fund managers begin tax-related selling, because their fiscal years typically end Oct. 31. If money managers book losses on beaten-down stocks to offset their winners and minimize capital gains distributions, their block trades can exacerbate any downdraft in stocks.

Psychologically, investors often are jittery at this time of year because of memories of some devastating autumn events -- including the 2001 terrorist attacks and the 1987 market crash. So any sell-off could quickly become a self-fulfilling prophecy, Keller said.

But some say the concerns about seasonal trouble are overdone.

“Everyone is talking about how we’re entering a seasonally weak period. I don’t think it’s going to happen, precisely because everyone expects it,” said Brett Mitstifer, senior portfolio manager at Value Line Asset Management in New York.

And if a pullback does come this month or next, Mitstifer said, he would view it “as a reason to buy stock, not a reason to sell,” because of his faith that the business outlook is gaining momentum heading into 2004.

As investors return from summer vacation, here are some of the questions they may ponder as they face the decision of whether to buy, hold or sell:

* Can the economy sustain its rebound well into next year? Few Wall Street pros doubt that the economy has momentum now. But what if it can’t keep up that head of steam in 2004?

“I think investors are focusing on the direction of the recovery, not its strength and sustainability,” said Brett Gallagher, head of U.S. equities at Bank Julius Baer & Co. in New York.

He believes that the economy still is burdened by excessive consumer and corporate debt, which will act as weights on the recovery’s momentum, he said.

NWQ’s Bosse worries that investors banking on robust economic and corporate earnings growth in 2004 could be disappointed as companies grapple with high costs for energy and other raw materials, health-care benefits and pensions.

“I don’t think we’re going back to the days when the economy could grow 5% and earnings could grow 15%,” he said.

Market bulls say that even if average earnings growth is in single digits next year, it will be enough to make stocks a more interesting place to be than most of the alternatives.

* Are interest rates headed higher or will they stabilize? Treasury bond yields have rocketed since mid-June as the economic data have improved. The 10-year T-note yield ended Friday at 4.46%, up from 3.11% in mid-June though down from the one-year closing high of 4.56% reached Aug. 13.

The Federal Reserve has pledged to keep its benchmark short-term rate anchored at the current 45-year low of 1% for the foreseeable future.

But longer-term interest rates are set by market forces, not by the Fed.

Value Line’s Mitstifer said that if bond yields surge anew, taking the 10-year T-note yield above 5%, that could provide unwanted competition for stocks.

On the other hand, yields on money market mutual funds and short-term bank savings accounts won’t be providing much competition for stocks as long as the Fed keeps its base rate at 1%.

There is a record sum in those short-term accounts -- $6.5 trillion, Fed data show. If investors were to funnel even a small portion of that money into the stock market, it could help to keep the rally alive, analysts say.

* Will the market rally’s recent leaders stay in charge? The gains this year have been led by smaller stocks and by technology issues.

The average mutual fund that focuses on small-capitalization growth stocks is up 30.7% year to date, according to Morningstar. By contrast, the average large-capitalization growth-stock fund is up 19%.

In a bull market, smaller stocks often take the lead initially, analysts say. In part that’s because smaller firms’ fortunes often are tied closely to the economy’s swings.

But the dramatic rebound in tech shares, in particular, concerns some market veterans who say the stocks are again pricey relative to earnings prospects.

Strength in August in some old-line industrial stocks heartened market bulls, who saw the shift as a sign that the rally is broadening.

A Morgan Stanley index of 30 so-called cyclical stocks, including many heavy-industry issues, jumped 5.3% in August, compared with a 4.5% rise for the Russell 2,000 index.

* What’s the message from the gold market? Gold futures prices reached $375.70 an ounce in New York on Friday, near a seven-year high.

The metal’s strong performance in recent weeks has left some analysts mystified. Because gold historically has been an inflation hedge, some people wonder if the market is telegraphing a troubling rise in inflation in 2004.

Others say gold buyers could be foreshadowing some new global economic disaster, such as a collapse of the dollar or another major terrorist attack.

Indeed, terrorism remains the fear common to all investors; there’s no way to know what another attack on U.S. soil would do to markets or the economy.

The basic worry about rising gold prices is that the metal’s ascendance often is at the expense of financial assets. “Generally, higher gold prices aren’t good news for most stock prices,” said Robert B. Howard, editor of the Positive Patterns market newsletter in Springfield, Mo.

Yet some analysts say the rise in gold’s price may indicate nothing more than rampant speculation by momentum-oriented traders.