Does the market have staying power?

Specialists and treaders working on the floor of the NYSE watch the monitors Tuesday as the Dow surges 378 points.
Specialists and treaders working on the floor of the NYSE watch the monitors Tuesday as the Dow surges 378 points.
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The past two years have seen countless bear market rallies - traps that lured investors back into stocks for yet another round of painful losses. So beaten-down investors can be forgiven for asking whether the latest rally, which seemingly came out of nowhere, is for real.

In just four sessions the Dow Jones industrial average and other broad market indicators have soared more than 13 percent, while the tech-intensive Nasdaq composite index is up 15 percent. Last week, stocks appeared to be surging in the face of mixed economic news, but by Tuesday traders at least could point to an emerging pattern of third-quarter earnings reports that have met or exceeded expectations - albeit lowered ones.

The latest crop of reports included decent earnings from Bank of America Corp., Citigroup and Fannie Mae, along with Dow component Johnson & Johnson, on top of positive earnings news last week from PepsiCo and Yahoo. After the market closed Tuesday, the encouraging pattern was broken by technology bellwether Intel, which missed Wall Street expectations and issued cautious guidance.

Scott McAdams, president of Seattle-based brokerage McAdams Wright Ragen, said investors had been particularly nervous about bank earnings.

“These are not wonderful numbers on a year-over-year basis, but they are a little better than people’s worst-case scenarios, and in some cases not so bad,” he said.

Larry Wachtel, senior market analyst at Prudential Securities, agreed.

“These quarterly results — they didn’t blow anybody’s socks off,” he said. “But they made the numbers, and in a world of lowered expectations that’s all you really need on Wall Street. ... I don’t think a roaring bull market is at hand, but I think the worst is over.”

McAdams said he was encouraged by what he perceives as a shift in psychology as the earnings season gets under way in earnest.

“The market is starting to focus more on what life might be like in the middle of next year than on the immediate term,” he said. “There is always in the fourth quarter seasonable optimism about the next year. Last year that optimism proved to be unfounded. We’re not going to know whether that optimism is warranted or not for some time.”

Market sources also said technical factors are boosting the market, including heavy buying by traders covering short positions. But many analysts said they were impressed the rally had held up despite a weekend bombing in Indonesia that appeared to be the deadliest terrorist attack since 9-11.

Waiting game
Tom Arrington, a senior portfolio manager for Nations Funds in St. Louis, said it is far too early to say whether the latest surge signals the end of the long, grinding bear market that began in March 2000. He pointed out that stock prices rallied nearly 20 percent over a few weeks in July and August before giving it all back and more.

“For the average investor I would probably wait until you start to see more confirmation of the economy strengthening and corporate earnings improving,” he said. “We’ve had such a strong move since last Thursday that it’s not going to be easy from here. There’s been a quick pop - we could very will give it back. … Dollar-cost averaging is still a good strategy.”

After a dispiriting pre-earnings “confession” season that sent stock prices to their lowest levels in five years, the early crop of earnings has provided some encouragement to market insiders. In particular analysts have concluded that earnings appear to be strong enough to hold off a nightmare scenario of a deflationary spiral - at least for now, said Hugh Johnson, chief investment officer for First Albany Cos.

“The focus for some time has been on the economy generally and earnings specifically,” he said. “The question that’s facing us is, Are the economists right? And is the earnings recession about to end and an earnings recovery about to begin? The reason the stock market is up for four days is that we’ve had good earnings, and deflation is another step removed.”

While deflation is still considered a remote possibility by most analysts, strategists fear that weak earnings would force companies to stimulate demand by cutting prices, triggering a vicious downward cycle. While those worries persist, with valuations having been beaten down to attractive levels, Wall Street is willing to “climb a wall of worry” at least for now, he said.

Intel’s results, reported late Tuesday, could cast a shadow over trading activity Wednesday. In extended-hours trading after issuing the news, the semiconductor giant fell more than 11 percent to $14.58 a share.

Choppy trading ahead
But even the most optimistic analysts say the market has come so far and so fast that some profit-taking is inevitable, and that means choppy trading in the weeks to come.

“People are so jittery that the minute things start to turn down money is going to come off the table,” McAdams said. “It’s going to be some time before people believe this is a secular rebound.”

“The market obviously has come to life here,” said Andy Engel, senior research analyst with the Leuthold Group in Minneapolis.

“People are establishing real positions that they are hoping to hold onto for a longer time period,” he said. “We think we’re early in a bull market phase, but it’s not going be a straight shot up.”