Stocks’ Slump Raises Fears of Bear Market

The stock market, like the economy, may be at a crucial crossroads: The next major turn could dictate the direction for a long time to come.

The slump in key stock indexes last week, before and after the shockingly weak July employment report issued Friday morning, deepened this year’s decline on Wall Street and raised fears that a new bear market could be underway -- less than two years since the last one ended.

The technology-heavy Nasdaq composite index plunged nearly 6% last week and is down 17.5% from its January peak. By one rule of thumb, a decline of 20% or more signifies a bear market.

The losses in other major indexes have been less severe. Still, stocks have reached a “tender point,” said Tom McManus, investment strategist at Banc of America Securities in New York. Many investors, he said, are weighing whether this still is a bull market, or whether stock prices are headed for a more serious setback.

The July employment report, which showed that the economy created a net 32,000 jobs in July -- far below expectations -- added to the gloomy mood that has dominated Wall Street since late June.

Concerns that the economy has slowed have been compounded by record-high oil prices, worsening violence in Iraq and new terrorism warnings.

The Dow Jones industrial average, which slid 147.70 points, or 1.5%, to an eight-month low of 9,815.33 on Friday, has tumbled 620 points, or 5.9%, since the end of June.

Many market pros say pessimism about the economy has been overblown. Although the July employment gain appeared dismal, other data have suggested that business activity picked up last month after weakening in June.

Investors’ recent actions imply that “we’re rushing headlong into another economic downturn,” said Tad Rivelle, a principal at Metropolitan West Asset Management in Los Angeles.

He doesn’t agree with that view. “We’re slowing, but we were growing at 4% to 5% [in terms of annual gross domestic product], which wasn’t sustainable,” Rivelle said.

The stock market’s main concern about the economy is its effect on corporate earnings, which underpin share prices. Second-quarter earnings reports, overall, have been robust: For the 90% of companies in the blue-chip Standard & Poor’s 500 index that have reported so far, operating profit is up 25.3% from a year earlier, according to earnings tracker Thomson First Call in Boston.

Including the second quarter, earnings have grown at more than 20%, year-over-year, for four consecutive quarters -- a rare occurrence, Thomson said.

But some investors have focused on the number of companies that have warned that their results in the second half wouldn’t meet expectations.

Through Friday, 69 companies in the S&P; 500 had said their third-quarter or second-half earnings would be below analysts’ estimates. That was up from 42 companies that had warned about upcoming results at this same point in the second quarter.

Even so, the ratio of negative to positive earnings forecasts by S&P; 500 companies, at 1.6 so far this quarter, is below the historical quarterly average of 2.0, Thomson said.

Despite the hand-wringing over the economy, the pullback in blue-chip stocks this year suggests that most investors aren’t too worried, some market optimists say.

The S&P; 500 index, at 1,063.97 on Friday, is down 8.1% from the 22-month high it reached in February. The Dow is down 8.6% from its high, also set in February.

Those declines are within the parameters of a correction, or a temporary pullback within a bull market.

“I think we are working our way through a market correction, and the typical correction pushes prices down about 10%,” said David Brady, president of Brady Investment Counsel in Chicago.

With many stocks at their lowest prices since late last year, “things are really starting to look attractive,” he said.

Technology stocks are down more sharply, but their rebound last year also was much greater than that of the average blue-chip stock, analysts note.

The Nasdaq index reached a bear-market low of 1,114.11 on Oct. 9, 2002. At its 2004 peak of 2,153.83 on Jan. 26, the index had rocketed 93% from its 2002 nadir.

By contrast, the S&P; 500 index’s rebound from its bear-market low to its high earlier this year was 49%.

Some profit-taking would be expected after gains like those. But could the market’s losses this year, and particularly in the last six weeks, be a prelude to much worse?

Many analysts don’t think so. They contend that the ingredients aren’t present for another bear market, meaning a deep and sustained decline in stock prices.

If the economy continues to expand, albeit at a slower pace, corporate earnings should continue to grow, market bulls say. Analysts’ current estimates have third-quarter earnings for the S&P; 500 companies rising 15% from a year earlier, fourth-quarter earnings rising 15.6% and full-year results in 2005 advancing 10.1%, according to Thomson First Call.

The average blue-chip stock is priced at about 15 times estimated 2005 earnings per share, said Kevin Caron, market strategist at Ryan, Beck & Co. in Florham Park, N.J.

The market has been much cheaper than this at various times in the last half-century. Yet with the plunge in Treasury bond yields last week on economic concerns, and the potential for the Federal Reserve (which meets on Tuesday) to slow its pace of boosting short-term interest rates, stock valuations are compelling when viewed alongside the alternatives of bonds and “cash” accounts such as money market funds, Caron said.

“I’m getting itchy to buy stuff here,” he said of the stock market.

The big question is whether more investors will share that sentiment soon -- or whether many will decide that the smarter move is to sell equities.

Even some analysts who aren’t excessively bearish believe it’s better to be cautious than brave at this point.

Standard & Poor’s investment policy committee in New York last week advised clients to lower their portfolio allocation from 45% U.S. stocks to 40%, the third such reduction since mid-June. The S&P; committee raised its recommended cash allocation to 40% from 35%. (The rest of the recommended portfolio: 10% foreign stocks and 10% bonds.)

S&P;’s attitude is that investors should be wary about buying U.S. stocks “until the economy shows signs of renewed strength or the market bottoms firmly,” said Joseph Lisanti, editor of the S&P; Outlook investment newsletter.

Bearish analysts believe that the market has a lot further to drop.

Steve Hochberg, chief market analyst at research firm Elliott Wave International in Gainesville, Ga., believes that the rebound that began in October 2002 wasn’t a new bull move but a bounce within a longer-term bear market.

The pattern charted by major stock indexes this year -- with each short-term rally resulting in a peak price below that of the previous rally -- “is the definition of a downtrend,” Hochberg said.

What’s more, classic measures of investor sentiment show that most people aren’t too fearful about what might happen to the market, he said. That’s often a contrary indicator, meaning that the market often ends up fooling the majority.

One gauge of investors’ fear level is the so-called VIX index, short for volatility index. It measures investors’ use of “put” and “call” options on the S&P; 500 index. A high VIX reading means investors are rushing to buy put contracts as a way to hedge against a falling market.

High VIX readings often occur just as the market is bottoming. But Hochberg noted that the VIX index, at 19.34 on Friday, was far below the peaks it reached at the end of major market sell-offs in recent years.

That suggests that investor sentiment could get much worse, triggering a much steeper slide in stock prices that could feed on itself, Hochberg said. “It’s only a matter of time,” he said.

Bearish analysts say that any number of things could be the tipping point: a change in the wording of the Federal Reserve’s statement on Tuesday, another jump in oil prices, more downbeat economic data or a terrorist attack, for example.

Bulls and bears alike say the next few weeks could well determine the longer-term trend.

The bullish view, Caron said, is that “the market now has positioned itself for a lot of bad things to come to pass.”

Investors, he said, ought to at least consider what stocks might be worth if those bad things don’t happen.