An Oct. 20 article on the stock market's recent rebound misstated the relationship between bonds' prices and their interest rates. The prices and the rates move in opposite directions. (Published 10/24/02)
After one of the best weeks in history for the Dow Jones industrial average, investors have one question on their minds: Has a stock market rebound begun, or is this yet another fleeting rally?
Stocks rose sharply on six of the last seven trading days and the Dow has risen more than 14 percent from the five-year low it hit a week and a half ago. Some analysts are pointing to a convergence of tantalizing signals that have marked the end of other severe bear markets -- improving corporate earnings, volatile stock prices, overpriced bonds and signs that investor pessimism is so low it has nowhere to go but up.
But others point out that corporate and economic news remains mixed and that stocks are still relatively more expensive than they were at the end of previous downturns. Add to that the uncertainty about war and terrorism, and there's little reason to believe the market has hit a bottom, they say.
In the past year or so, the market has heated up twice -- most recently in late July -- only to fall back to new lows.
"There's no disputing that the markets have been impressive, but I don't see it as sustainable," said Brian Piskorowski, a market analyst at Prudential Securities. "We've seen this all before."
Still, those who believe that the worst is over say they have history on their side. The rebounds from recent bear markets -- after the energy crisis in the early 1970s and the 1987 market crash -- followed roughly this pattern:
Corporate earnings begin to improve, encouraging professional investors to buy and hold stocks, rather than trading on a hair trigger to take advantage of each market fluctuation. Investment money begins to flow out of bonds -- generally considered safe havens in a downturn -- and into equities. Ironically, just as a market starts an upswing, public sentiment plummets, and panicked investors begin selling in massive volume or betting against the market. The bottom comes when almost everyone who wants to dump stock has done so, leaving prices approaching historical lows.
"Last September and July fooled a lot of people, but the only times we've seen that are similar to the last two weeks are 1987 and 1974, when markets found a bottom," said Paul Hickey, an analyst at Birinyi Associates, which studies stock market trends. "We think it happened again during the second week in October."
Even with the recent rally, stock prices are on the verge of finishing down three years in a row for the first time since the Depression, and many are calling it the worst bear market in 70 years.
Some of the current optimism springs from improved earnings. Last week was the busiest of the quarter for earnings announcements. With 200 companies having reported so far, those that met or beat analysts' expectations have outnumbered those that fell short by six to one, according to Jeff Applegate, chief investment strategist at Lehman Brothers. The August rally, which fizzled to new lows by early October, was preceded by a gloomier earnings season. A positive earnings outlook is one factor that will be required to sustain a recovery, Applegate said.
But not everyone is convinced. Some analysts question just how good the third-quarter earnings results have been. "Sure a lot of companies beat expectations, but the expectations were ratcheted down so far for many of them that it may not mean very much," said Piskorowski of Prudential Securities. For example, the market surged Thursday on news that International Business Machines Corp. had earned $1.69 billion (99 cents a share), beating projections. But as recently as a month ago, the analysts' consensus on IBM's earnings had been 99 cents a share, before they were gradually lowered to 96 cents a share, according to Thomson First Call.
Data about the economy can be just as difficult to read. During the recent rally, investors have been told on the positive side that housing construction is on the rise and that the third-quarter growth of the economy may have been better than many expected. But they were also told recently that consumer sentiment had fallen to an eight-year low and that retail sales are on the way down. As a result, predictions of the economy's growth vary widely, with some saying the rate could be as good as 4 to 5 percent next year and others expecting a contraction at the start of 2003, which could signal a "double dip" recession.
"People are buying on every bit of good news and selling on every piece of bad news, which is contributing to volatility in the market," said James A. Bianco, president of Chicago-based Bianco Research.
The recent rally has boosted the Standard & Poor's 500-stock index by nearly 14 percent since Oct. 10. Most analysts historically have considered that a 20 percent gain means the market has recovered. But that has not always proved true. From September 2001 to January 2002, for example, stocks gained more than 21 percent before plunging to new depths. And again, in July and August of this year, the market soared more than 20 percent before testing new lows this month. In that same period, the tech-heavy Nasdaq has gained 20 percent five times, and each time it has fallen back.
Another potential recovery sign cited in the past week was that massive inflows of money into the stock market preceded the rally, as was the case during the bull markets that followed stock market lows in 1974 and 1987.
"Money preceding a rally means that people are seeing some positive valuations out there, rather than trying to make quick trading gains," said Hickey of Birinyi Associates, who has calculated that investors have pumped some $2 billion into the equity markets since a day or two before the recent rally began. Back in August, Hickey said, money did not begin flowing into the equities market until a day or two after the rally had already started.
But the move into stocks by professional investors is far less striking than one might expect if a genuine market recovery were underway, argues Robert Adler, president of AMG Data Services, which tracks the flow of money into mutual funds. According to Adler's data, money continued to flow out of equity mutual funds during the recent rally, though the rate of outflows may have slowed. "People might be waiting to make a more considered decision after being disappointed a few times already," Adler said.
A real recovery would require a belief by investors that stocks are cheap. Some analysts say they are. According to Hickey, less than 25 percent of New York Stock Exchange shares are priced above their average price over the past 200 days -- a sign, he said, that valuations are low. In the six previous times this has happened since 1994, Hickey said, the S&P 500 has grown by an average of almost 15 percent in the six months that followed.
But for every analyst who says stocks are now a steal, there is one who says prices will only go lower. Price-to-earnings ratios, which are used to measure stock valuation, were actually lower, on average, before previous market recoveries.
Many analysts suggest that the recent poor performance of the bond market could be another sign that stocks are set to rebound. The S&P 500 underperformed 10-year Treasury bonds by 66 percent between January 2000 and Oct. 9 of this year, according to Applegate. Investors responded by shifting a record amount of money out of equity mutual funds and into bond funds in the third quarter of this year, according to AMG Data Services.
But in the past 11 days, stocks have outperformed bonds by 20 percent, as bond yields have soared, driving up their prices. "If you look back at previous times the market has made a bottom, immediately afterwards stocks tend to start outperforming bonds," Applegate said. Others, though, see the recovery of stocks vs. bonds as just a natural rebalancing.
When a rebound does come, history suggests that stocks will rise quickly. In 1974, the market reached a low on Oct. 3 and was up 20 percent and on the road to recovery by Nov. 5. In 1987, the market bottomed out in December and was considered bullish three months later.
But just as there could be a reward for buying at a market bottom, there is a penalty for guessing wrong.
"If people jump back in and it turns out it was too early, the losses will just keep piling up," said Alan Ackerman, market analyst for Fahnestock & Co., a financial services firm.