Investors look for the right entry point
The U.S. economy is getting a lot worse in a hurry, by many accounts. But the stock market isn’t.
Share prices overall have bounced modestly from what were multiyear lows for many issues in January. And the bears have had trouble getting any sell-offs to stick in recent weeks despite the ongoing gloom about the slowing economy and rising inflation pressures.
For many investors who were horrified by the losses on their January investment statements, February has brought some relief.
Two camps are facing off here. One camp is betting that, even if the economy is in or near recession, the market will do what it often does -- which is start to rally before the next economic pickup begins.
Investors’ fearful mood is a good thing, in a contrarian kind of way, market bulls say.
“It’s hard to get too negative here because there don’t seem to be any positives,” says Paul Hickey, co-founder of Bespoke Investment Group in Harrison, N.Y.
In other words, the best time to buy stocks usually is when you can’t find a good reason to do so.
The other camp says the bulls just don’t get it. This isn’t going to be a garden-variety recession, they say.
The economic boom of the last six years was fed by a spectacular borrowing binge centered in the housing market. Now, with the financial system reeling from losses on mortgage debt and banks increasingly unwilling to lend money, the economy is like an addict going cold turkey.
That tax-cut stimulus package aimed at fending off recession? Good luck, says Merrill Lynch & Co. economist David Rosenberg, who is one of Wall Street’s biggest pessimists at the moment.
“The offsets to the ferocious headwinds posed by a credit contraction are very likely to prove inadequate to prevent this recession from becoming one of the most severe of the postwar era,” he says.
Still, the stock market largely has held its ground for the last four weeks after a brutal plunge in the first half of January that left many broad indexes in bear territory -- meaning that they were down 20% or more from last year’s record highs.
The Standard & Poor’s 500 index ended Friday at 1,353.11. It’s up 3.2% since it reached a 16-month low on Jan. 22.
It isn’t that the bears have given up trying to take stocks lower: On Friday the New York Stock Exchange said the number of “shorted” shares zoomed to a record 14.37 billion as of Feb. 15, up 4.8% since the end of January.
In a typical short sale, a trader borrows stock (usually from a brokerage’s inventory) and sells it, expecting the market price to drop. If the price indeed slides, the trader can eventually buy new shares in the market to replace the borrowed stock and pocket the difference between his sale price and the repurchase price.
Shorting also is a strategy for hedging market bets. Whatever the motivation, short selling puts downward pressure on prices.
But the surge in shorted shares in recent months also has left the market ripe for a sharp snap-back. If prices begin to rally, short sellers often rush in to close (or “cover”) their bets because they lose money with every uptick. Their buying, in turn, can add substantial fuel to any rebound.
The market’s sudden turnaround Friday had an air of panicked short-covering to it. Stocks were in the red for most of the session, until CNBC reported that a rescue plan for ailing bond insurance company Ambac Financial Group Inc. could be announced early next week.
That triggered a rush of buying, particularly in beaten-down financial issues, and most market indexes closed the session with gains.
Larry Adam, chief investment strategist at brokerage Deutsche Bank Alex. Brown in Baltimore, is in the optimists’ camp. He’s betting that, even if the economy gets worse in the near term, lower interest rates and the Bush administration’s tax rebates will lay the groundwork for a recovery later in the year.
If he’s right about the economy, Adam says, “now’s the time to get back into the market.”
For better or worse, every analyst turns to history for guidance at times like this. Looking back to 1989, Adam found four periods in which broad indexes of financial company shares dropped 25% or more. Each time that threshold was crossed proved to be a great buying opportunity in stocks, he said.
This time around, the average financial issue in the S&P; 500 index is down 29% from the record high reached a year ago this month. Overall, the S&P; 500 is down 13.5% from its all-time high set in October.
Many market bulls say the most compelling case for stocks is that prices are reasonable, if not cheap, relative to companies’ earnings.
Based on estimated 2007 operating earnings per share, the average price-to-earnings ratio, or P/E, of the S&P; 500 companies is 15.8, according to earnings tracker Thomson Financial. Based on analysts’ estimates for 2008, the P/E is 13.7.
The point being, the market is nowhere near the lofty valuations of the late 1990s, when many blue chips commanded P/Es of 20 to 30.
What’s more, analysts are expecting a big rebound in earnings in the second half of this year to make up for weakness in many industries in the first half.
But if the economy falls into a deep recession that lasts into the second half, the anticipated earnings pickup won’t occur. Instead, earnings could fall instead of rise, in which case current share prices wouldn’t look quite so inexpensive.
Still, stock investors can at least draw some comfort from the fact that, unlike in the late 1990s, equities aren’t outrageously overpriced.
Then again, what has ailed markets since last summer hasn’t had much to do with stocks in any case.
The problem is in the credit markets and the severe damage done to the financial system by the housing market’s meltdown.
Merrill Lynch’s Rosenberg says he agrees that stocks will begin to rebound well before the economy starts emerging from its funk. In the last five recessions, the S&P; 500 bottomed out 60% of the way through the slump, on average, he says.
Rosenberg just figures the funk this time is going to last a lot longer than Wall Street’s bullish camp wants to believe.
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