Even for Bulls the Vibe Is Bad--and That Could Be Good

For seven years, the U.S. stock market has enjoyed more happy endings than the least believable Hollywood sitcom.

No matter what the challenge--and there have been plenty of them for this bull market--stocks on the whole have refused to give back much ground for very long. It’s as if the permanent symbol of Wall Street is that obnoxious 1970s smiley face.

And so it is that we start 1997 with the Dow Jones industrial average at 6,448.27, just 112.64 points from its record high reached last Friday, after surging 26% in 1996 and a total of 173% since the bull was born in mid-October 1990.

Happy New Year?

Hardly. This has suddenly become a market that almost everyone is in but about which almost no one has anything good to say--at least not so far as the next 12 months are concerned.

“Be realistic” is the refrain used by both bulls and bears. Many bulls believe that, at best, U.S. stocks will eke out low-single-digit gains in 1997.

Many bears, meanwhile, argue that an honest reality check on Wall Street would reveal the most precarious stock market since perhaps 1987--the year the Dow industrials crashed 36% over a two-month period.

Hence, “Sell now--the next bear market is at hand!” shrieks longtime market guru Elaine Garzarelli, who expects major stock indexes to drop perhaps as much as 25%.

“Something bad is going to happen. It’s just a question of how bad,” warns Barton Biggs, the widely followed investment strategist at Morgan Stanley & Co., who expects the average stock to lose as much as 30% of its value this year.

You’ve heard this all before? Of course you have. And lest you think that this entire story will be an ode to bearishness, it won’t be. In fact, there’s a strong argument that expectations for stocks now are so low, something good is just as likely to happen in 1997 as something bad.

But to give the bears their due, there are some unpleasant realities hovering over this aged bull market like so many threatening alien spaceships:

* By almost any measure--dividend yield, share prices relative to underlying asset values, share prices relative to earnings--the average stock is as richly priced as at any time in modern history.

* Individuals poured an estimated $220 billion in net new cash into stock mutual funds in 1996, far surpassing the previous record of $129.6 billion set in 1993. But the pace of inflow in the second half of the year was 40% below the first-half pace, suggesting an increasingly reluctant investor--even among aging baby boomers who supposedly have no choice but to invest aggressively.

* Federal Reserve Board Chairman Alan Greenspan, in raising the question of possible “irrational exuberance” in financial markets during a Dec. 5 speech, sounded to some analysts like the Greenspan of late 1993--when he was constantly warning, directly and indirectly, that the Fed was likely to tighten credit in 1994 (which it did, temporarily pummeling stocks).

* History argues strongly against the possibility of three consecutively great years for stocks. With one exception, the six other periods of this century when blue-chip stocks rose powerfully two years in a row--as they did in 1995-96--were followed by sharp declines in prices.

* Finally, and perhaps most ominously, the powerful growth in corporate earnings that has supported the bull market since 1993 is unquestionably waning. The average blue-chip company’s earnings from continuing operations are estimated to have risen 8% to 10% in 1996, after leaping 16% in 1994 and nearly 18% in ’95.

This year, the most bullish Wall Street analysts expect earnings to rise about 10%, on average. Many experts think the gain will be much less, owing to slower U.S. economic growth, rising wages, ever more intense competition and many companies’ inability to wring more efficiencies out of already tightly run operations.

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With less-impressive profits to underpin stocks, the bears see virtually no margin for error in this market. Any negative surprise could start a selling panic, the bears argue. And with stock mutual fund managers so fully invested--fund cash reserves have fallen to just 5.8% of assets, on average, the lowest in 20 years--managers have little cushion to protect themselves should individual investors begin bailing out.

But why would they? That is the missing link in the bear chain of events: a good reason why people should leave stocks soon en masse.

True, the market scared many people in July, when prices suddenly dove on worries about higher interest rates and slower corporate earnings growth. The Dow fell from 5,778 points on May 22 to an intraday low of 5,175 on July 15, a 10.4% loss in all, before rebounding.

Yet if that decline didn’t turn into something much worse, why should another such normal pullback incite panic? Consider: Even though individuals shoveled less cash into stock funds over the last six months than in the first half of 1996, November’s inflow of $17.1 billion still was more than the funds took in during any single month of 1995--and stocks had no trouble rising in that year.

Bernard Schaeffer, head of the Investment Research Institute in Cincinnati, believes there is a tendency on Wall Street to underestimate the tests this market has faced over the last seven years, and how well stocks have held up when challenged.

“Market pullbacks have generated high levels of fear, but we have only pulled back [each time] to key support levels,” meaning to prices that have quickly generated fresh buying interest, Schaeffer said. “Successful tests of support levels only add to the credibility of the bull market.”

The bulls’ main case for another decent year for stocks in 1997 is that the economic and interest rate environments don’t appear to hold the necessary ingredients for triggering a classic bear market, usually defined as a drop of at least 15% to 20% in key stock measures such as the Dow.

“The things that usually bring down bull markets are still not here: rising inflation or the Fed tightening credit or some external shock,” said Eric Miller, strategist at Donaldson, Lufkin & Jenrette Securities in San Francisco.

The global economy, in fact, remains incredibly stock-friendly. Inflation is subdued in most countries, central banks have generally easy monetary policies and the world is still embracing free trade, business efficiency and, in a growing number of countries, the U.S. concept of creating “shareholder value” through corporate mergers and stock buybacks.

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Bears like Barton Biggs concede all of that. “My response . . . is that equity valuations are at sky-high levels, and all the good news is already in prices,” he says. Moreover, he adds, “it’s the sociological signs of excess that really bother me. The cult of equities is too accepted. My instinct is very strong that things have been just too good for too long” for stocks.

In other words, Biggs thinks most investors are simply too optimistic about stocks’ potential and must be reminded the hard way that prices periodically go down as well as up, even if it is true that stocks are the most lucrative investment over the long term.

His concern about the “cult of equities” is shared by many market pros. They are frightened by recent investor surveys showing that nearly half of stock mutual fund owners don’t believe stocks will lose even 10% in any one calendar year over the next decade.

“That doesn’t leave much room for disappointment, but it does leave a lot of room for panic” if stocks fall sharply for whatever reason, said James Stack, the bearish publisher of the InvesTech market newsletter in Whitefish, Mont.

Are Americans woefully unprepared for disappointment in the stock market? Perhaps. But for as heavy an investment as people have made in stocks in this decade, there has also been a huge buildup of cash in safe short-term accounts. Assets in basic short-term accounts at banks and S&Ls;, for example, have jumped to $1.25 trillion from $1.14 trillion a year ago, according to Federal Reserve Board data. Money market fund assets also have continued to rise, to nearly $900 billion now. In comparison, stock mutual fund assets total $1.76 trillion.

Ned Riley Jr., investment strategist at the Bank of Boston, believes that many investors have “barbelled” their assets, buying stock funds aggressively but also keeping large cash reserves because of a basic suspicion that stocks’ good times can’t last.

Some of that cash is conceivably just waiting for an opportunity to buy stocks at cheaper prices--potentially providing a backstop if the market should stumble badly.

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The investors holding that cash could also be motivated to buy stocks for another reason: if the surprise is that things go right for the market this year.

What if the U.S. economy continues to grow at a moderate pace, generating decent corporate profits but little inflation? What if the Japanese and European economies pick up a bit of speed, but not enough to trigger sharply higher interest rates? And on the political front, what if President Clinton and Congress hammer out a balanced-budget agreement, which then produces a rally in the bond market, pulling yields lower?

The bear case doesn’t allow for things to go right, or assumes that it won’t matter--stocks will fall no matter what.

Optimists such as Schaeffer note that an occupational hazard of being bearish is that you can become trapped by your own rhetoric. “The more people get confounded by the market, the more dire their forecasts become. It puts more of the bears in ‘apocalypse’ mode,” he said.

Michael Stolper, head of San Diego-based financial advisors Stolper & Associates, thinks the bears are prematurely trying to call the end of what could be a very elongated “up” cycle for financial assets such as stocks, one fueled by favorable economic conditions and powerful demographic trends.

“It feels funny to make money for this long. Nothing is more troubling to people than prosperity,” he said, because the natural tendency is to worry that the good times will soon end. “But the good news doesn’t have to end soon,” Stolper said. “The big mistake is trying to quantify euphoria.”

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Stolper thinks the 1990s bull market won’t end until stock prices become far more overvalued than the bears say they already are. The average blue-chip stock now is priced at about 20 times estimated 1996 earnings per share, but Stolper notes that nothing says that price-to-earnings ratio can’t go much higher.

Most bullish analysts, however, aren’t forecasting a new level of mania for the market. Typical of the non-bear camp is Arnold Kaufman, editor of Standard & Poor’s Outlook investment newsletter in New York. He thinks the S&P; 500 index will end 1997 at about 770--a mere 4% gain from the 1996 close. Add in a 2% dividend yield, and that would mean a total return of 6% on blue-chip stocks this year.

For the risk entailed, Kaufman said, investors would be better off owning three-year Treasury notes, which pay 6.03% in interest.

Still, if you sell all of your stocks now, as Garzarelli and other bears suggest, will you know when to get back in? And will you have the guts to buy at the bottom?

There’s certainly nothing wrong with being realistic, even cautious, in a market like this. But for most truly long-term investors, it’s probably smarter to resolve to never be fully out of stocks--and to never be fully in with more than you can afford to lose.

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Anatomy of a Bull Market

Stocks’ run has been spectacular...

The Standard & Poor’s-stock index soared 20.3% in 1996, excluding dividends, for its 10th gain in the last 12 years

1996: +20.3%

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...as corporate earnings have risen sharply...

Earnings from continuing operations (before write-offs) for S&P; 500 companies, per share:

1996: $42.40

1997: $47.00 (Estimate)

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...and interest rates have stayed in a fairly narrow range

Yield on five-year Treasury note, quarterly closes:

1991: 7.73%

1996: 6.21%

* Sources: Standard Poor’s; Bloomberg Business News