Bullish Investors Need Reality Check

Sun Mar 17, 8:21 AM ET

By Pierre Belec

NEW YORK (Reuters) - Federal Reserve (news - web sites) Chairman Alan Greenspan (news - web sites), in his most exuberant assessment of the economy in more than a year, recently spoke the words that launched stocks on a rocket ride: "An economic expansion is already well under way."

But some Wall Street veterans worry that the bulls may be rushing into a trap that could be called "Irrational Exuberance, Part 2."

In his semiannual report to Congress this month, the Fed chief seemed to signal the end of what may have been one of the briefest recessions in history. Investors, seeking to get even after getting slammed by crumbling stock prices last year, put on their buying boots and waded back in with the type of vigor not seen since the wild days of the 1990s bull market.

The Dow Jones industrial average is up nearly 5 percent for the year. The Standard & Poor's 500 index has poked its head above water after being submerged for most of the year.

Indeed, the market's performance has been remarkable since the Dow sank to a 3-year low of 8,236 on Sept. 21 shortly after the devastating attacks on the United States. The Dow has zoomed nearly 30 percent, S&P jumped 20 percent and the technology-laced Nasdaq composite climbed more than 35 percent, clearly putting the key stock gauges in a classic bull market mode, defined as a rally of 20 percent or more from their lows.

The bullish enthusiasm this week sparked Salomon Smith Barney to up its target for the Dow to 11,400 from 10,800 previously.

But veteran traders say investors and Greenspan, who famously warned about "irrational exuberance" in the stock market in December 1996, are both suffering from "Irrational Exuberance, Part 2." The old-timers say the bulls will need to come to their senses and wait for hard evidence that the recession is in fact over and then for corporate earnings to improve. A balancing act would appear to be in order.

"The majority of commentators did not see the recession coming, didn't believe it when it arrived, minimized it when they acknowledged that the economy indeed was in recession, and now the current wisdom is that there was no recession after all," says James Dines, publisher of the Dines Letter, and a long-time investment adviser based in California.

There's too much optimism in the market, says Dines, who believes that cash and gold are the safest places to park money.

"What if we turn out to be wrong,?" he says. "You would be stuck with cash and that is hardly the worst fate imaginable." RUN FOR YOUR LIFE

Dines bet: A major stock market sell-off that will be more bone-jarring than most people envision. "Our advice is to run for your life," Dines says.

A case can be made that the economy is rebounding. Growth in the fourth-quarter gross domestic product was revised to the upside and workers' productivity shot up at the fastest rate in two years while labor costs sank.

Unfortunately, corporate earnings went into a nosedive, posting their biggest drop in recent memory, thus the disconnect between economic optimism and the corporate earnings. The slump in corporate profits shows one important thing: Corporate America is selling goods but can't make the profits that would normally fuel the stock market.

Yet, investors have pumped up the price-to-earnings ratio of companies in the S&P to a whopping 22 times this year's earnings, according to the tracking firm Thomson Financial/First Call. This is just below 26 times when the S&P last set a record high in March 2000. The norm for the P/E is 15.

It's fair to say that investors are still not correcting to reasonable expectations. Never in the history of past recessions have so many people been so bullish and stocks so overvalued while the economy was on shaky ground.

Bullish investors may again be proven wrong in a big way, and the nice paper profits they amassed in March could evaporate just as quickly.

The jury is still out on whether the recession is over and the expansion under way. In past recessions, the economy has fooled Wall Street, initially signaling a recovery that turned out to be a mirage.

DOUBLE-DIP ANYONE?

"A double-dip alert always bears repeating in the depths of recession," says Stephen Roach, chief economist for Morgan Stanley. "One of the two classic preconditions of the double-dips has already fallen into place -- a massive rate of (business) inventory liquidation in the fourth quarter of 2001."

What is likely to happen is that once the stimulus from this inventory drawdown is exhausted, the economy will stall, and the recovery may prove to be a dead-cat bounce.

"I think the case for a double-dip is quite compelling," Roach says. "Following on the tendency of five of the past six recessions, I suspect double-dip could commence by springtime."

Talk of a full-blown recovery is meaningless until there is sustained spending by businesses, which has been the weak link that slam-dunked the economy into recession a year ago. And in order for businesses to continue to buy more stuff, sales will need to accelerate relative to inventories, which will bring fatter profits.

The trend lately among businesses has been to let inventories run down and to hold back on new production and hiring more workers until there are clear signals of a rebound in consumption.

News of an unexpected drop in the nation's jobless rate in February buoyed the Street, but the numbers were only bullish relative to economists' low expectations.

The dip to 5.5 percent from 5.6 percent in January was caused by one-time factors such as the unseasonably warm weather that boosted construction jobs and the return of laid-off automobile workers. Traditionally, the jobless rate increases in a recession and workers continue to get pink slips even as the economy recovers.

Experts say the drop in unemployment can't be sustained and they expect the jobless rate to increase to more than 6 percent by the middle of the year.

Many companies are facing cutthroat competition and can't raise prices.

The only way that a lot of businesses can move their goods is through massive discounting, for example, Detroit's teaser zero-interest rate on loans to buy cars. So in this kind of climate, it would be foolhardy to expect companies to regain their stamina any time soon.

ACCOUNTING PROBLEMS

Then, there's the accounting brouhaha. The betting is that first-quarter earnings will be ugly as companies are forced to adjust to stricter accounting rules following the Enron Corp. mess. A lot of nasty problems were hidden during the boom years when the high-flyers made bad acquisitions and the resulting write-offs are bound to slam their results.

Also there are massive credit problems. Moody's Investors Service, the credit rating firm, has downgraded five times the number of companies that it upgraded in the first quarter.

Investors need a reality check because the backdrop for a bull market may not be as rosy as they think.

For the week, the Nasdaq fell 3.2 percent to 1,868, the Dow gained 0.3 percent to 10,607 and the S&P 500 rose 0.2 percent to 1,166.

-- Irrational Exuberance Part Deux (Dead Cat Bounce @ Double-Dip. Recession), March 17, 2002

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-- (Roland@hatemail.com), March 17, 2002.