STOCK WATCH


What's Next for This Market?

Jeffrey R. Kosnett

Despite this week's turmoil, the rest of 2007 still looks bullish. But here are four possible hitches.



During the plunge and right after the market closed on February 27, I had a few conversations with financial planners and advisers. Mostly, we were talking real estate. But the dive in the Dow trumped our discussions of the Donald's realm.

One wealth manager in San Diego said, "Our investors, and I, are immune to one-day movements." From Albany, N.Y., a second told me that she advised a couple of clients with cash to buy some CDs but also to invest in a mid-cap growth fund. On February 28, the day after the debacle, I asked my friend and index-fund fan Rob Moody in Atlanta if he would advise any changes to your long-term stock allocation. "Nope!" he said with conviction, adding that if you happen to be seriously underweight in stocks, sell some bonds or bond funds and adjust your stock percentage back to where you want it. But given the fact that Tuesday's 3% loss followed months of vigorous gains, you're probably not light on stocks. And if you have an automatic deposit going into a retirement fund on March 1, don't change a thing.

It's especially important to avoid letting emotions control your investment decisions. It's long been evident that post-crisis panic selling is dangerous, even immediately after 9/11, when all of us were stunned and in the dark. A 400-point drop is rare, but it's been so long since we've had even a 100-pointer that it's plausible all the pent-up selling got telescoped into a one-day window. Five years ago, you had a 3% movement one day every month, up or down. My colleague Anne Smith expertly summed up the events of February 27 -- the causes and Wall Street's reactions -- in the previous edition of Stock Watch (see An Unnerving Market Drop). I'll discuss some upcoming matters that could be further cause for concern -- but only mild concern. The bull market is in force until further notice.

Spring earnings season. Corporate America keeps defying fears that profit growth will decelerate dramatically and send stocks into a drip-drip-drip retreat -- the sort that really does inflict a lot of pain and anxiety. Nearly all of the Standard & Poor's 500 have reported fourth-quarter 2006 earnings. The median gain is 13%, better than the 10% Zacks had forecast and the single-digits-by-the-end-of-2006 prediction that was common a year ago. If 13% sounds pedestrian relative to the past couple of years, remember that those leaps were inflated by spectacular energy profits. Energy had little to do with this latest quarter. The strength was comfortably broad-based.

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Pretty soon, though, it will be time for companies to start pre-announcing results for the quarter that ends in March. Pay attention, because this is a perilous period. If the CEO of a bellwether company such as IBM or General Electric says negative things that can be interpreted as thumbs-down on business conditions, serious investors will give this view credence, and their selling will jeopardize the bull market. Zacks says to look for first-quarter earnings growth of 8%. If Zacks is right and corporate America fails to beat those expectations, stock prices could weaken.

An end to merger mania. Stock prices and mutual fund returns are getting a boost from mergers and buyouts, many by private-equity investors who pay big premiums to buy businesses because they do not need to worry that the stock price will subsequently go down. If the people controlling these oceans of money get nervous about bidding for more companies, this also implies a fall in confidence. That would be bad for stocks, especially such sectors as retail and real estate that have been the scene of gobs of rich buyouts. So if there are other mega-deals soon such as the ones for Texas Utilities and Equity Office Properties, take a breath and give thanks. Your mutual funds' managers will.

Consumer trouble. Too much is made about consumers turning tail because their houses aren't appreciating 15% this year or they're worried about interest rates going up. In real life, people buy what they need, either because they have jobs and families or real-life events get in the way. People need to fix their cars or spend $1,000 on veterinary surgery. They take vacations because school shuts for a week and wait 45 minutes for a table at a popular restaurant because it's Friday night and it's time to unwind from a busy work week. But look at some of the biggest one-year winners in stocks: Priceline, CarMax, American Eagle Outfitters, Tempur-Pedic, and, yes, Big Lots. They don't sell essentials. If Wall Street interprets the next round of government data as evidence that shoppers are tired of shopping, retail stock prices will plunge. That will lead to shallow news coverage that claims that Americans are once again suffering from economic angst. That's not good for stocks.

Inflation. Last time I looked, gasoline prices were up, and when that happens, the inflation genie then appears. That, in turn, feeds the assumption that interest rates aren't coming down, so price-earnings ratios stay flat or fall.

That's because higher inflation and interest rates eat at the real value of future earnings and dividends. The continued bull case rests not only on economic growth and earnings but also prospects for higher P/E ratios, especially for stocks of large companies. Wal-Mart, to take one example, closed on February 28 at $48.31, which is 17 times the company's earnings for the past four quarters. Analysts estimate that the discounting giant will earn $3.20 a share in the year that ends next January. If Wal-Mart's P/E ratio remains at 17, the stock moves to $54 -- a decent gain but nothing special. But if Wal-Mart can get its P/E to 18 or 19 -- not a huge reach for a company of this quality and dominance -- you have the makings of a bull market.




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