Peter Morgan  /  AP file
Major forces are aligning to deliver gains on Wall Street, namely higher earnings and growing corporate cash piles.
updated 6/20/2005 5:41:55 PM ET 2005-06-20T21:41:55

The stock market seems more and more like a broken record these days. The Dow Jones industrial average closed at 10,500 and change on June 1, 2, 9, and 10. In fact, for 17 straight trading days starting in mid-May, the Dow closed within 54 points of 10,500, basically a rounding error of half a percent. This is right where the Dow was at the end of March, the middle of January, and last Thanksgiving.

But it would be a mistake to assume the Dow will still be at 10,500 six months from now. Take a closer look at this go-nowhere market, and you'll see that the odds favor 8 percent to 10 percent gains by yearend. You could even improve your chances, and maybe even do better than the market, by correctly picking a couple of promising stock sectors, such as health-care companies and large-cap growth stocks, and wisely avoiding some others, such as finance and banking companies and small-cap value stocks.

The major forces aligning to deliver the gains are higher earnings and growing corporate cash piles. All that money enables companies to make acquisitions, buy back stock, or increase dividends. These boosts are coming to a stock market in which prices are relatively sane, perhaps because the most reckless speculators have moved on to the real estate market. Indeed, stocks have already started rebounding from the year-to-date lows struck in April. Says Tobias Levkovich, chief U.S. equity strategist at Citigroup Smith Barney: "We're back into a rally phase."

Of course, not everyone agrees. Bear, Stearns & Co. investment strategist François Trahan recently warned that the market is likely to fall 4 percent by January, although he is looking for a rebound next year. Central to Trahan's worry is that rising short-term interest rates, engineered by the Federal Reserve, are approaching incredibly low bond-market yields, producing a nearly flat alignment of interest rates that traditionally comes with a stalling economy. Because of the atypical interest-rate environment, the stock market is going to be especially sensitive to any news that points to a weaker economy, Trahan argues. Another concern in the market: Earnings growth is slowing down to half its 24 percent pace of last year.

Some seers are also warning that the bull market -- up 45 percent from the Dow's low of 7,268 in October, 2002 -- is getting a bit long in the tooth. That's 32 months without a significant drop, a long time compared with the run of 23 months that the average bull market takes to reach its peak, according to Minneapolis-based Leuthold Group, a money manager and research firm. "We are late in the game here," says Andy Engel, senior research analyst at Leuthold. The firm still sees the market picking up an additional 4 percent or so before falling off.

Onward and upward
Chances are the market is more likely to be at the start of a new step up than the beginning of a decline. The doubters' arguments are relatively weak, as negative stock market factors go -- especially compared with the forces of recession, terrorism, and the bursting of the tech stock bubble that battered the market earlier this decade.

The Fed's rate hikes, often ominous in the past, haven't been a big deal this time around and may well stop soon. The increases have come gradually since June, 2004, without shocking the financial system. Many economists, including most prominently Fed Chairman Alan Greenspan, say the low yields in the bond market may not be signaling a slowing economy at all. Instead, they may be the result of new dynamics in global capital flows that the Fed chief confesses he doesn't fully understand. Whatever the reasons behind the low yields, they're also translating into lower interest expenses for corporate borrowers. That gives earnings a boost and encourages mergers and acquisitions.

It is not necessarily bad for stocks, either, that bond yields and short-term interests rates have come closer together. Even when credit spreads -- the difference between Treasury rates and all others -- are widening at the same time, as they are now, it's not necessarily bad for equities. When that has happened at other points during the past 50 years, stocks have delivered 9% average returns after inflation in the following 12 months, according to Lehman Brothers Inc. chief U.S. equity strategist Henry "Chip" Dickson. With interest rates still so low, earnings have to grow only about 3 percent for stocks to be attractive vs. bonds at current prices, according to estimates by Bridgewater Associates, a major hedge-fund manager.

Indeed, earnings growth is probably the most dependable force to carry stocks higher. Analysts at Standard & Poor's expect that earnings underlying stocks in the S&P 500-stock index will climb 11 percent this year and next year, too. Those gains should translate almost directly to higher share prices because stocks don't have to carry a lot of hope and hype these days.

Stocks are trading at 15 times earnings estimated for the next 12 months. That's not only reasonable, but low compared with the median price-earnings ratio of 18 over the last 15 years, according to Dickson. What's more, the earnings estimates behind today's ratio are probably conservative. Wall Street analysts and company executives have become more cautious making estimates since the tech stock bubble burst and regulators stepped in with new rules.

Investors, too, are more careful, which also bodes well for the market. It shows just how much the market and attitudes have changed that Dickson feels exceptionally bullish when he predicts 10% returns over the next 12 months, including a kick from dividends of nearly 2 percent. Back in 1999, strategists had to call for gains that were twice that much before they sounded like real bulls. But the tech stock bust and the S&P's declines of the next three years -- of 10 percent, 13 percent, and 23 percent -- purged much of the speculation and folly.

Investor skepticism is so deeply ingrained in stock prices that it wouldn't take much additional buying to give the market a lift. Prominent potential stock bidders on the horizon include publicly traded corporations themselves and financial buyers, such as private buyout shops and hedge funds. Much of the potential here starts in the $631 billion of cash on balance sheets of industrial companies in the S&P 500. The money amounts to nearly 8 percent of companies' market value, according to Standard & Poor's. That's almost as much as it was in 1988, when it generated a wave of leveraged buyouts.

Wallowing in deals
With investors pressing company executives to use that cash, momentum is building for more buybacks, dividends, and mergers and acquisitions. Some 381 companies in the S&P 500 bought back $82 billion of their own stock in the first three months of the year, a 91 percent increase in dollars from a year before. Dividends from the S&P 500 companies rose 16 percent, to $49 billion, in the first quarter compared with a year earlier.

At the same time, dealmakers announced $422 billion in M&A this year through May, up 20 percent from the same time the year before and up 177 percent from two years before, according to Thomson Financial. Buyers of all types are striking big deals, and hedge funds are pushing corporations to restructure to get their stock prices up. Just days ago, hedge-fund operator William Ackman disclosed he had bought 9.9 percent of Wendy's International Inc. putting the stock in play. The stock climbed 3 percent on the news.

More deals are sure to follow. Richard Peterson, chief market strategist at Thomson Financial, says LBO firms are raising tens of billions of dollars to stake new acquisitions. "We're on track for a trillion-dollar year of U.S. M&A," says Peterson.

While all of those forces point to a strong market generally, certain types of stocks will probably prove better investments than others. Stocks with large market capitalizations, dividends, and steady earnings growth are quickly becoming favorites among institutional investors and Wall Street strategists. Examples recently recommended by Henry McVey, U.S. equity strategist at Morgan Stanley, include PepsiCo, Yum! Brands, and Medtronic. Many money managers see the move to large-cap growth stocks as a logical shift following five years of exceptional performance by small value stocks. Brian Gendreau, investment strategist at ING Investment Management, says growth stocks tend to do best in the later stages of the business cycle. They are unusually cheap compared with the value stocks, he notes.

In contrast, banking stocks are falling into disfavor and probably won't recover for a long time. Their earnings tend to rise and fall with the spreads between short- and long-term interest rates. With that spread narrow now, they're under pressure and to be avoided, says David B. Scott, senior vice-president of Chase Investment Counsel, which manages $3.9 billion in Charlottesville, Va. Another sector to avoid is real estate investment trusts. While REITs' high dividend payouts are appealing, they have been bid up too high. REITs tracked by the Leuthold Group are trading at a 12 percent premium to the value of their holdings. Since 1996, the REITs have usually traded, on average, at a 2 percent discount to their assets.

Citi's Levkovich says that even if you play the market right and catch a rally now, you'll still need to stay alert. Come January, the odds may turn again, and the Dow may head back to 10,500.

Copyright © 2012 Bloomberg L.P. All rights reserved.


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