So the Dow Jones industrial average ended the week at 3910, up 113 points and less than 2 percent off its all-time high of 3978? It was a spooky celebration, nonetheless, say a growing number of bears. They feel that stocks, with valuations already stretched, could snap if the market moves up much more.
Now all they have to do is sell that message to individual investors, who regularly ignore the old Wall Street adage and prefer instead to buy high and sell low. A move by the Dow to new records could embolden many to pour more money into equities -- especially if the blue-chip barometer hurdles 4000 -- just when they should be backing off because risks are rising. "This is the only merchandise in the world which becomes more attractive to buyers the more expensive it gets," jokes Kidder Peabody analyst Dennis Jarrett.
If anything is a bargain right now, it may be bonds and utility stocks, which have already suffered through a 12-month bear market. Overly worried investors continue to dump them at distress prices. Meanwhile, much-despised cash has been the real king of investments this year. Despite a paltry 3 percent-plus return, money market funds and other cash equivalents have outpaced both stock funds, down 0.5 percent, and bond funds, off 3.2 percent, for the first nine months of 1994.
In effect, the markets are attempting to sort out a welter of conflicting signals: A surprisingly boomy economy has driven up corporate earnings, but it has also triggered fears of rekindled inflation. To forestall such an outburst, the Federal Reserve Board has engineered a rapid rise in interest rates. "At some point we're going to have a day of reckoning among these conflicting forces," says Katherine Hensel, chief investment strategist for Lehman Brothers.
But not yet. Fears of inflation were allayed somewhat last week by government numbers portraying a moderation in growth and little in the way of price pressures. Industrial production was flat for the first time in 15 months. The consumer price index rose 0.2 percent in September; producer prices actually fell. Interest rates eased on the news, and the drop, plus strong third-quarter profits by corporate behemoths like Chrysler and Motorola, pushed up the Dow.
The week's action was a far cry from the 10 percent fall in the Dow early in the year to just under 3600 in April. What then unnerved the stock market was the Fed's rat-a-tat-tat series of hikes in short-term interest rates starting in February. Falling rates had provided much of the fuel for the bull market in equities, so when rates reversed course, stock investors were caught flat-footed.
High-stepping rates have already devastated the bond market and could still threaten stocks by siphoning money from the market. And the rise may be far from over. Bear Stearns chief economist Wayne Angell, who until February was a member of the Fed, expects the central bank to notch the benchmark federal funds rate up by half a point next month and maybe by another half a point in December. That would lift it to 5.75 percent by year's end, against 3 percent when 1994 began.
If the Fed can pull off a "soft landing" for the economy, slowing growth from the current 4 percent rate to a sustainable 2.5 percent in 1995 and holding inflation down, a bullish case makes some sense. "I'm optimistic that as the economy slows and interest rates level off and perhaps fall a bit, equities will continue to rise," says Byron Wien, the chief investment strategist for Morgan Stanley. But the Fed has never been very good at such fine-tuning. It either hits the brakes too hard, throwing the economy into recession or holds back, letting the inflationary cat out of the bag.
No-win effort? Even a successful effort by the central bank may not help equities. "The Fed could tighten to the point where the economy slows just enough, but that will cause earnings to tail off, which won't be good for the stock market averages," observes Rod Linafelter, portfolio manager of the Berger 100 Fund.
The most persuasive argument against another big bull move is that stock market averages are approaching overvaluation levels that haven't been seen since just before the 1987 crash. The normalized price-earnings ratio on the Standard & Poor's 500 stock index stands at 20. It was 23 at the market's high in 1987. "The market is extraordinarily overpriced by any rational criteria," declares Michael Metz, chief investment strategist for Oppenheimer & Co., a Wall Street brokerage. In his view, the peak achieved by stocks at the end of last January may be it, not only for 1994 but for the next few years, with the Dow falling below 3000 before the next bear market ends. Others are less pessimistic. Kidder Peabody's Jarrett predicts the Dow could drop to 3400 in the next few months but then sees stock prices moving up rapidly in 1995 as earnings catch up to valuations. His target for next year: 4300 to 4500.
Investing abroad appeals to some analysts because foreign markets have already gone through substantial corrections and stocks there are less pricey than stocks here. U.S. exports are surging as the European and Japanese economies recover and clamber onto what some see as a global growth bandwagon that will really get rolling in 1995.
"From where I sit, I'm glad I don't have to invest in the United States," says John Hickling, portfolio manager for the Fidelity Overseas and Fidelity Japan funds. He points out that European stock markets, measured against local currencies, are down 10 to 15 percent so far this year. Thomas Herzfeld, whose eponymous investment firm specializes in closed-end mutual funds, also likes Europe. He recommends Emerging Germany, New Germany, First Iberian and Scudder New Europe, all closed-end funds that trade on the Big Board and are selling at big discounts to their net asset values.
Bonds, already battered, now yield far higher returns than they did a year ago. At the current yield of around 8 percent, the government's 30-year bond "represents real fundamental value," asserts David Bostian, a strategist for Herzog Heine & Geduld in New York. Even if inflation moves to 4 percent, that still would give investors a solid 4 percent real return, a full percentage point above what fixed-income investors traditionally demand.
Utilitarian buys. Like bonds, interest-sensitive utilities have been clobbered -- the Dow Jones utility average is off 30 percent from its high 12 months ago. "Sure they're cheap, but you have to stick with quality names that don't have problems like nuclear power or too much debt and won't wind up cutting their dividends," says Jim Floyd, a senior analyst with the Leuthold Group, a Minneapolis investment firm. Utilities meeting these criteria, which currently yield 6 to 8 percent, include Ipalco Enterprises, Wisconsin Public Service, Portland General, Montana Power, Scana Corp. and FPL Group.
But in uncertain times, cushy cash is good to have in reserve should opportunities arise. The conventional wisdom these days is for "long term" investors to simply sit tight and ride out any declines because timing exits and entries is futile. And Gerald Loeb noted in The Battle for Investment Survival, a frequently reprinted classic that was first published in 1935, that holding lots of cash may seem wimpy -- but it is what separates "the professional stock-market investor from the loss- taking amateur." The key to making money in stocks, he said, is to own lots of them only when the rewards are much more substantial than the risks. "It is far better to let cash lie idle than to buy just to `keep invested,'" he wrote, concluding that individuals who follow this rule are "often kept out of a dangerous market." Not bad advice for what could be some chilling months ahead.
