Investor Mood Swings

By Brooke A. Masters and Terence O'Hara
Washington Post Staff Writers
Sunday, May 14, 2006

The Dow Jones industrial average is inching toward its record high, the economy grew like gangbusters last quarter, and we've had double-digit-percentage increases in corporate earnings for nearly three years.

Hold on to your hats. It can't keep going like this.

Upbeat bulls are clearly in the majority on Wall Street right now, and truly negative bears are hard to find. But many stock traders and market analysts can identify reasons to be worried about the current state of affairs, and some are actively predicting at least a short downturn by the end of the year.

"We're in a market that I call taurus longaevus [Latin for "aged bull"]. It's getting long in the tooth," said Joe McAlinden, chief global strategist for Morgan Stanley Investment Management. "We're in a cyclical bull market that started in October 2002, and there's a lot of evidence that these things typically last three to 3 1/2 years."

Bob Doll, chief investment officer for Merrill Lynch Investment Managers, is similarly concerned. "Risks usually build as the market goes higher," he said, adding that he is predicting a small market downturn in the second half of the year, though not a full-blown economic recession.

And their views have some resonance with the broader market. Although on Tuesday the Dow pulled to within 100 points of the 11,722.98 record, set in January 2000, it has since fallen more than 250 points, to 11,380.99. And the Nasdaq slid about 4 percent in the week.

To cautious analysts, the worrisome signs are varied and not entirely clear.

Gold futures, often a haven for "gold bugs" -- investors concerned about inflation and geopolitical or stock market turmoil -- rose above $700 in New York this week for the first time since 1980. Silver is at a 25-year high, and copper and platinum both set records in the week, though copper pulled back a bit by week's end.

Some segmented or industry-specific sector indexes, such as those tracking small-cap stocks and real estate investment trusts, have already hit their all-time highs, even though the broader market has not. The housing market is showing signs of cooling off. New-home construction has been a major engine of economic growth, and many homeowners have relied on home-equity loans to support their spending.

Crude oil prices are hovering around $72 a barrel on concerns about unrest in Nigeria and tension with Iran over its nuclear ambitions. Oil prices have more than tripled since the current stock market boom began in late 2002. High gasoline prices pinch consumer pockets, possibly lowering demand, and high oil prices translate into higher costs for many businesses and increase the chances of inflation.

"We continue to expect pressures on [profit] margins as costs rise. We are very concerned about the consumer sector," said Wendell Perkins, chief investment officer of Johnson Asset Management. "We've been surprised by the strength of the market."

Most observers agree that two of the biggest risks rights now are inflation and some kind of unforeseen geopolitical shock, such as a terrorist attack that undermines a major economy or unrest that seriously cuts into oil supplies.

"Energy prices are a wild card. It's more expensive, and geopolitically, there's more unrest," said Arthur Hogan, chief market analyst at Jefferies & Co., who is generally optimistic but is mindful of potential problems.

Traders say they are particularly concerned about how the new Federal Reserve Board chairman, Ben S. Bernanke, will respond to the first signs of serious inflation. In several past economic cycles, the central bank brought on a bust by tightening up too much on the money supply.

"The economy is very strong now," said Vanguard Group Inc. chief investment officer Gus Sauter. "The winds could change, obviously. The Federal Reserve has been tightening to try to engineer a soft landing. So far so good, but it's a tricky job. They don't have scalpels to work with, but saws and hammers."

While not predicting a bear market, Sauter advises, as he always has, a healthy mix of caution and optimism.

"We recommend a balanced portfolio at all times," said Sauter, who oversees investment strategy for the Valley Forge, Pa., mutual fund company. "Don't try to time this thing. Don't throw caution to the wind, and don't over-hedge. People whipsaw themselves when they try to change their strategy based on what they think will happen in the next year."

Morgan Stanley's McAlinden says he, too, is concerned about inflation and is also disquieted by mutual fund data that suggest that small investors are pouring into small-company and international stock funds, where much of the recent growth has been concentrated.

"Investors are chasing recent performance," he said. "I'm running with the herd right now, but there is going to be a time this year when you will want to break away from the herd. You'll want to buy large-caps; you'll want to buy bonds."

A longtime professional money manager, McAlinden calls himself a "white-knuckle bull," but he sounds pretty bearish when he compares the current era with the 1970s, noting that back then, oil prices were high, the United States was fighting an unpopular war and there was turmoil in the Middle East. The oil shock of the '70s sparked a period of prolonged inflation. "I'm beginning to think the gold bugs have it right," McAlinden said. "If the inflation numbers look bad, I think [the Fed] will tighten, which is why I think it'll turn bearish by the end of the year."

Another potential source of trouble is in the currency markets, where the dollar has dropped 6 percent against the Japanese yen and 8 percent against the euro in 2006, said Jane Caron, chief economic strategist for Dwight Asset Management Co. "That could start a problem with foreign demand for U.S. equities and U.S. Treasurys, and that could cause a vicious circle."

Susan Stewart, chief executive of Charter Financial Group Inc., a Washington investment-management firm, said that the U.S. markets are sturdy but that she is looking to several international investments for the real growth.

"We think overall that the growth will be slow here and stronger in certain markets," she said. Stewart's firm focuses on buying a small basket of rigorously selected stocks, just 25 of them at the moment. One is an Australian mining and metals producer that she thinks is positioned well to benefit from the rise in Asian economies.

She also has a recession hedge. "We own beer and Band-Aids," she said, citing two products that sell well no matter what the economy does.

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