Monday, October 9, 2006

After the Dow Record: Gloom or Boom?

News Analysis
October 9, 2006

Business Week Online

After the Dow Record: Gloom or Boom?

Big-cap stocks should continue to outperform in the wake of the Dow's all-time high, analysts say. But a slowing economy could pose pressure

By now, Wall Street is probably running out of unpopped champagne bottles. On Oct. 5, the Dow Jones industrial average closed at a new all-time high for the third consecutive trading session. The broader Standard & Poor's 500 index cruised to its best levels since February, 2001.

Stocks have slipped a bit since, but blue-chip indexes remain near historic peaks, buoyed by falling energy prices and growing optimism that a housing slowdown won't derail the economy. On Oct. 6, the Dow closed at 11,850.21, just below its record finish of 11,866.69. The S&P 500 ended at 1,349.58. Already, some on the Street predict the Federal Reserve will begin cutting interest rates next year.

Investors who remember what happened the last time the Dow reached all-time highs can be excused for feeling a little nervous. The blue-chip benchmark's Jan. 14, 2000, peak didn't just precede a dramatic market downturn. It marked the start of nearly six years of large-cap underperformance (see BusinessWeek, 4/17/06, "Blue Chip Blues").

This time, however, many bulls and bears agree that market leadership has finally shifted to stocks of big companies (see, 10/2/06, "Small Caps: Out in the Cold"). The question is whether the Dow will pace the market higher through a mild economic slowdown, or whether the economy is poised for more drastic weakness. While analysts say this might be a good time for investors to reallocate part of their stock holdings toward large caps, some cautious investors may want to reduce their overall equity exposure, too.

THE BULLS' OUTLOOK.  The bulls see historical patterns working in their favor. The S&P 500 has rallied during the fourth quarter in 16 of the last 18 years, for an average gain of 5%, notes Jeff Kleintop, chief investment strategist at PNC Wealth Management (PNC ). This year, the resolution of midterm election uncertainty and a continued downtrend in energy prices may help ignite the fourth-quarter fanfare, Kleintop says.

Though the blue chips may be at record highs, the "irrational exuberance" of the tech-bubble years simply isn't there, others say. At the S&P 500's all-time high in March, 2000, the forward price-to-earnings ratio for the index was 26, compared to a p-e of 15 now, observes Brian Gendreau, an investment strategist at ING Investment Management (ING ). Gendreau expects the rotation into large caps to continue. "Someday a new high is going to be a peak," he says. "But I don't think we're there yet."

Chris Johnson, managing quantitative analyst at Schaeffer's Investment Research, suggests that investors will be taking their money off the sidelines and bringing it to the big caps. Johnson's down on tech giants like Microsoft (MSFT ) and Apple (AAPL ), but he favors telecom stocks like AT&T (T ) (see, 9/22/06, "Breaking Away from 'Over Loved' Stocks"). "Nobody likes to be missing out on a party, and the party right now is with the Dow," Johnson says.

THE BEARS' PERSPECTIVE.  Nevertheless, the bears have their own historical trends to tout. The Dow is at the top of a three-year trading channel, during which each short-term peak has been followed by a decline, according to Barry Ritholtz, chief market strategist at Ritholtz Research & Analytics. Ritholtz adds that an economic "soft landing" is a rare occurrence, and says investors should prepare for a downturn before getting excited about potential Fed rate cuts.

Jay Suskind, co-head of capital markets at Ryan Beck, agrees there's a real chance of this soft landing turning hard. "I would suggest taking a little money off the table," Suskind says. "I think the market's really ahead of itself."

In the Treasury market, an inverted yield curve—when short-term rates are higher than long-term ones—continues to herald gloomy tidings. The yield curve has a perfect track record for predicting recessions when it remains inverted for three months or more, notes Liz Ann Sonders, chief investment strategist at Charles Schwab (SCHW ), in an Oct. 2 report. "The rally has been built on the back of a 'Goldilocks,' or soft-landing scenario," Sonders says, arguing that slowing corporate profits may darken that rosy picture.

BIG CAPS IN ANY CASE.  Rising costs and slowing economic growth will put the brakes on earnings, concurs Richard Berner, chief U.S. economist at Morgan Stanley (MS ). Overseas business may ease the pain, but not enough to stop profits from falling, according to Berner. "While I've been incorrectly expecting earnings growth to fade for a while, this time it's for real," he says in an Oct. 6 note.

Quincy Krosby, chief investment strategist at The Hartford (HIG), also sees earnings slowing. She says this acceleration and increasing risk aversion will prompt investors to keep rushing to the relative safety of big caps. Meanwhile, Thomas McManus, chief investment strategist at Banc of America Securities (BAC ), is another market watcher predicting slowing earnings and continued large-cap outperformance.

The shift to big companies' stocks may be just one more reason to consider low-cost index funds. "The financial markets have experienced a virtually unprecedented period of market breadth, which has greatly benefited active managers," says bearish Richard Bernstein, chief investment strategist at Merrill Lynch (MER ). "We think that period might now be coming to an end."

Ultimately, this isn't 2000. While the Dow's record highs do mark a psychological milestone, this time analysts say blue-chip stocks should continue to outperform the broader market. How long they can keep it up may depend on who's right about the economy.

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