BW - This Market Rally Has Legs

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Investing
October 12, 2007, 12:01AM EST
Marcial: This Market Rally Has Legs

Recession fears are misplaced, and despite some sluggish sectors in the U.S., worldwide growth should keep pushing the numbers up
by Gene Marcial

The stock market is far smarter than a lot of people think. When the Dow Jones industrial average surged to finish the third quarter with a 487-point gain, or 3.6%, to 13,895.63—and then went even higher—many market watchers and media pundits were in total disbelief. They could attribute it only to what they described as a disconnect between economic reality and the market's optimism. Remember, however, the market has "fooled" a lot of people a lot of times, in both directions. It was just another of those times when the market, for reasons that admittedly are often hard to fathom, decided it liked what it saw ahead, beyond what most people observed.

There is a lot more to this market's advance than some may realize. And be prepared to ride with this rally, allowing for some speed bumps along the way, for the next 6 to 12 months. Some fearless forecasters predict that the Dow will streak to 16,000 and that the Standard & Poor's 500-stock index will go to 1,700 over the next 6 to 12 months. I agree with that forecast. Why? Let me be brief: It's the global economic boom.

The Market Is Over It Already
I'll give you a longer explanation. Through all the turbulence it has endured—including the deep drop last summer resulting from the credit crisis—the market returned with renewed vigor on Oct. 9 to score yet another record high. The Dow vaulted 120.8 points, or 0.9%, to 14,164.53—its 34th record close in 2007 and the 56th since the start of October, 2006. The S&P advanced nearly 1%, to 1,565.15, and the NASDAQ composite index jumped 0.6%, to 2,803.91.
The media attributed the gains to the Federal Reserve's nonincendiary comments at its Sept. 18 meeting that suggested the U.S. economy wasn't heading toward a recession. The decision by the Fed to cut interest rates in September was based on concerns that the credit turmoil could lead to slower growth at this time of extreme uncertainty. Such a conclusion was gleaned from recent Fed minutes, which also showed that the Fed members avoided language that could have suggested the U.S. economy will contract, as opposed to what some economists have been predicting.

But that was the excuse for the day. The real reason behind the market's continued rally, punctuated by some downswings, stems from its important role as a leading economic indicator. As such, the market has digested and moved beyond what many observers are now focusing on.

There is the disturbing plunge in home sales that has severely pulled down prices; fear that the credit crunch is not yet concluded, as major banks and financial houses are being crimped by huge losses and write-downs because of their involvement in the subprime mortgage mess. And there's more: skyrocketing crude oil prices; softening retail sales and slumping consumer confidence; weak industrial production and manufacturing activity; slowed durable-goods orders; and weakening corporate profits. And there's former Fed chieftain Alan Greenspan warning that the chances of a recession have increased. Of course, there is also the protracted war in Iraq, which is draining hundreds of billions of dollars from the national coffers. That's one big bundle of serious concerns.

No Classic Signs of a Recession
So what's there to be optimistic about, and what's the market suggesting? The market has factored in such fears and concerns early on—and may do some further readjusting along the way. In the meantime, the market seems able to argue that the worldwide economic expansion is riding high and will benefit not only overseas markets but also U.S. companies that are broadly exposed to foreign markets' growing consumption of goods and services. It is true that the U.S. economy isn't in good fighting shape. But whereas the big worry not too long ago was inflation, now the concern has shifted to the possibility of a recession. Yet here's the good news: The traditional markers of a recession, including a fall in commodity prices, rising unemployment, and unemployment insurance claims, are nowhere to be found. And the subprime problem and its ramifications shouldn't lead to a recession, according to some market watchers.

"The stress in the housing sector alone will not trigger a recession," argues Stanley Nabi, vice-chairman of Silvercrest Asset Management Group in New York. The U.S. economy, he adds, will continue to draw strength from government outlays, capital spending, and increasing exports. An additional and major fillip is the Fed's stance of remaining "friendly," at least until 2008, in terms of managing the direction of interest rates, says Nabi. In sum, the stock market, predicts Nabi, will continue to "plod along irregularly higher even in the face of sluggish growth in the U.S. economy."

Ed Yardeni, president and chief executive officer of Yardeni Research, who has written often about the major economic problems, says he isn't concerned. What could be an issue, he says, is the question of whether the stock market will be able to continue rising into record territory if the financial and transportation groups languish. Financial and transportation, he notes, together account for 28% and 21.8% of the S&P 500's earnings and market-cap shares, respectively. The only way the market can continue advancing, says Yardeni, is if industries and stocks that benefit from the global boom continue to gain earnings and market-cap shares in the S"P 500. "It assumes that the global boom will continue, as I expect," says Yardeni.

Worldwide Growth Stays Strong
With respect to the worldwide economic boom, international experts suggest that the strong pace of growth is continuing. Basically, the robust global economic growth we are witnessing—from China, India, and Latin America to Europe—remains intact in spite of the repercussions of the subprime crisis, says Stephen Leeb, president and chief investment officer at Leeb Capital Management, which invests heavily in both U.S. and foreign stocks.

Leeb notes that the International Monetary Fund in a recent report said that its 5% gross world product (GWP) growth forecast through 2008 hasn't been impaired by the credit crisis. The biggest impact of the global boom, says Leeb, is on U.S. companies with investments in foreign markets that aren't yet richly valued. Companies with footprints in the developed economies overseas will be the next batch of growth stocks, he says. This is one major reason why the U.S. stock market and bourses in other parts of the world will continue to rise significantly. Leeb believes the Dow will hit 16,000 in a year and the S&P should rocket to 1,700.

In the U.S. market, the big-cap stocks with vast foreign exposure such as Coca-Cola (KO), Johnson & Johnson (JNJ), Schlumberger (SLB), Boeing (BA), ExxonMobil (XOM), General Electric (GE), and American Express (AXP) will be the big winners over the next few years as the global economic expansion continues, Leeb predicts.

Strategies for Investors
On the other hand, U.S. companies that are mainly dependent on the U.S. economy for their growth will suffer. Retailers, for instance, are among those facing growth difficulties. Another group to avoid, says Leeb: Chinese stocks, including the major companies that trade in the U.S., such as PetroChina (PTR). The sharp rise of stocks in China's stock market is a concern and could affect even the Chinese stocks that trade in the U.S., should the bubble burst in that country.

Sam Stovall, chief investment strategist at Standard & Poor's, recommends investors overweight their portfolios in energy and information technology stocks because he believes they will benefit from above-average earnings growth prospects and international revenue exposure. Consumer discretionary stocks, however, should underperform, he says, as a result of the deteriorating economic environment, continued housing weakness, and high relative valuations. What's Stovall's forecast for the S&P 500? He says S&P's equity analysts, using their 12-month target prices for the companies in the S&P 500 index, project the U.S. large-cap benchmark to advance nearly 12% by the end of September, 2008, near the 1,700 level. (S&P, like BusinessWeek, is a unit of the McGraw-Hill Companies (MHP).)

To ardent market watchers, Oct. 10 is a milestone marking the bull market's fifth birthday. On Oct. 9, 2002, the S&P 500 index closed at a low of 776.76. That ended the bear market, which started on Mar. 24, 2000, that had eliminated 49% of the market's value. Will it crash by the end of its sixth year in 2008? The good news, notes Yardeni, is that while sentiment indicators have turned more bullish, the headlines warn about the soaring stock market amid dark economic news. It could all burst again. As an old Wall Street adage says, a bull market climbs a wall of worries. To that I would add another: Buy on bad news and sell on good news.

Marcial is Wall Street columnist for BusinessWeek.