Riding the Recovery

The recession of 2001 has given way to the recovery of 2002. And a recovering economy almost always has meant that stocks are the place to be.

After the devastating market decline of 2000 and 2001, that’s a welcome thought for many investors, of course.

But in the first quarter, Wall Street didn’t quite play along with the historical script. Stocks struggled to a mixed finish, unable to extend the powerful rally of the fourth quarter that followed the post-Sept. 11 dive in prices.

The blue-chip Standard & Poor’s 500 index closed virtually unchanged for the quarter ended March 28, though counting dividend income, the index’s “total return” was a positive 0.3%.

The average domestic stock mutual fund likewise posted a minuscule positive return of 0.4%, according to fund-tracker Morningstar Inc.

There were plenty of bright spots in the market in the quarter, including “value”-oriented shares, natural resources stocks and many foreign issues.

But the first week of the second quarter brought a fresh sell-off market-wide, raising new concerns that the next major turn on Wall Street’s roller coaster won’t be to the upside.

“On ‘the Street’ there’s a pretty good battle going on between the optimists and the pessimists,” said Ed Keon, investment strategist at Prudential Securities in New York. “We fall on the optimists’ side, but the pessimists have a good story as well: Their point is that the economic downturn was not that strong, so this recovery may not be much either.”

Lehman Bros. strategist Jeffrey Applegate also is an optimist, relatively speaking: He expects the rebounding economy to lift corporate profits this year, and believes share prices will advance as well. His year-end price target of 1,350 for the S&P; 500 would mean a 20% gain from the index’s Friday close.

“At this point in the economic cycle, stocks should outperform bonds,” he said. But the market’s fourth-quarter rally priced in a healthy portion of this year’s corporate profit recovery, he said. So stocks may not see the kind of gains this year that were typical after other recessions.

In fact, the market’s advance from its recession lows reached Sept. 21 has been modest, compared with the rallies following previous recession lows.

The S&P; 500 is up 16.2% since Sept. 21, and the Nasdaq composite index is up 24.4%.

By contrast, approximately 28 weeks after the market’s recession lows of 1990, the S&P; was up 28.4% and the Nasdaq index was up 48.9%.

Experts say investors have some good reasons for being cautious about pushing share prices higher, despite the economy’s apparent emergence from recession.

*

Waiting for Rebound in Corporate Profits

One key question is whether corporate earnings--the fundamental underpinning for stock prices--will rebound strongly in the second half of the year. Brokerage analysts are setting the target high for the third and fourth quarters, predicting a 38% year-over-year climb in earnings for the S&P; 500 companies in the period, said Robert Doll, chief investment officer at Merrill Lynch’s asset management division in New York.

Doll and others note that advance corporate warnings about first-quarter results have been lighter than usual, which suggests that the reports will be on target or better than expected.

But a wave of warnings last week from the software industry didn’t help investors’ confidence, and contributed to the week’s 4.1% drop in the tech-heavy Nasdaq composite index. Year-to-date the index is down 9.3%, after surging 30% in the fourth quarter.

If investors begin to question whether robust revenue and profit growth is possible later in the year, the market could struggle from here, with the major indexes notching gains in the high single digits--at best--for the year, Doll said.

One reason for caution is that consumer spending never withered in the 2001 recession, making it unlikely that a dramatic surge in spending will supercharge the economy, he said. What’s more, many analysts don’t believe that corporate capital spending will turn up significantly this year.

Along with the possibility of a choppy or muted earnings recovery, steep stock valuations are a key concern on Wall Street.

“By historical standards stocks are still fairly expensive,” Keon said, noting that the S&P; 500 trades for a price-to-earnings ratio of about 23 based on this year’s profit estimates, compared with its historical average P/E of about 15.

Valuations may limit the market’s upside, Keon said, because there is arguably little room for P/E ratios to expand.

In past economic recoveries, the market got a lift not only from rising corporate earnings but also because investors were willing to pay higher prices relative to earnings. Because the average P/E already is high, that P/E expansion may not happen this time.

Still, some market strategists say today’s equity valuations are reasonable in the context of benign inflation, relatively low long-term interest rates and federal income tax rates that are slated to continue to fall in 2003--all factors that tend to make stocks more attractive to investors.

*

Fed May Go Slow in Raising Rates

One potential market obstacle that isn’t troubling most professionals is the likelihood that the Federal Reserve will begin raising its key short-term interest rate this year from the current 40-year low of 1.75%.

In the wake of stronger-than-expected economic data in the first quarter, the Fed in March signaled that it may begin tightening credit later this year. But analysts note that the stock market usually has rallied in periods of economic recovery even after the Fed has begun raising rates from recession lows.

What’s more, many economists believe the Fed will be cautious in tightening credit this time because of concern that the recovery is tenuous.

One threat to the recovery is the surge in energy prices this year. Crude oil has shot up from $19.84 a barrel at year’s end to $26.21 a barrel as of Friday, driven in part by worries that the worsening situation in the Middle East could lead to an interruption in energy supplies.

Philip Orlando, chief investment officer at Value Line Asset Management in New York, believes the biggest risks to the stock market are “exogenous, tied to the Middle East one way or another. The Israeli-Palestinian situation is a powder keg. And then there’s Iraq and Saddam Hussein,” he said, referring to the possibility of a U.S. invasion.

Nonetheless, Orlando says investors shouldn’t underestimate the market’s potential this year.

“Earnings will really explode starting in the third quarter,” he said. There is typically an 18-month lag before the full effect of Fed interest rate changes is felt in the economy, he noted, and the Fed began its rate-cutting campaign in January 2001.

Prudential’s Keon likewise thinks the bulls will regain control of Wall Street this year.

“We’re not heading back to 1995--the boom years of 20% and 30% gains--but I wouldn’t be surprised to see something in the market’s historical range of 10% [for 2002],” he said.

The first quarter demonstrated that even in a struggling market, as measured by broad indexes, there can be plenty of stocks that do well. That puts the onus on mutual fund managers to earn their fees by picking well, as opposed to buying just about anything and hoping that a rising tide will lift all boats.

The funds shown in the charts on this page were the biggest gainers in their categories in the first quarter, which suggests that they had what Wall Street wanted in the quarter (though past performance, of course, is no guarantee of future results).

Many investment strategists say consumer-related stocks are likely to continue to fare well, which is typical in times of economic recovery. Investors can draw a parallel with 1981-82, a recession in which consumer spending also hung tough, Keon said. Despite the lack of a breather, spending accelerated coming out of that downturn, he said.

Wealth transfer through inheritances, a dynamic fueled by the 1990s stock market boom, continues to boost consumer spending, he said.

Keon suggests investors own a broad spectrum of stocks that can benefit from a recovery. Examples from his firm’s recommended list include such names as medical-products giant Johnson & Johnson (ticker symbol: JNJ), retailer Target Corp. (TGT) and technology names such as Microsoft Corp. (MSFT) and Intel Corp. (INTC).

Orlando said home builders and companies tied to the housing sector are well-positioned for 2002, despite their heady advance since September. The housing sector shows few signs of weakening, reflecting many Americans’ belief that homes still are among the best investments today.

As a group, home builders’ shares sell for about eight times analysts’ earnings-per-share estimates for 2003, Orlando said. Historically the sector reaches its peak valuation at a P/E that is about half the broad market’s P/E. If that holds true this time, the builders’ stocks could rise to a P/E of about 11 based on 2003 earnings estimates.

Builders Lennar Corp. (LEN), Centex Corp. (CTX), KB Home (KBH) and Pulte Homes Inc. (PHM) are highly rated by Value Line for their 12-month appreciation potential, and Orlando said he also likes housing-related companies such as carpet maker Mohawk Industries Inc. (MHK), appliance maker Whirlpool Corp. (WHR) and retailers Lowe’s Cos. (LOW) and Home Depot Inc. (HD).

Lehman’s Applegate said investment managers such as State Street Corp. (STT) and Citigroup Inc. (C) could benefit from an economic pickup, along with consumer-related stocks such as auto parts maker BorgWarner Inc. (BWA).

Smaller stocks also may continue to outperform their bigger brethren, as they have for the last two years, strategists say. That’s what happened after the 1974 recession, Keon noted.

*

Analysts Favor Small- and Mid-Caps

Current fundamentals also appear to favor small- and mid-cap stocks over blue chips, Merrill’s Doll said. On the whole, analysts forecast more vibrant profit growth from smaller companies this year. That makes sense, Doll said, because the fortunes of smaller companies tend to be more closely linked to the economy’s swings, given that the firms often are “further along in the supply chain” or make niche products whose sales benefit from economic strength.

But in the battered technology sector, usually a beneficiary of an economic turnaround, prospects are murky at best.

Although consumer spending probably will hold up, Keon said, the sharp slowdown in business spending may linger, taking a further toll on tech and telecom companies. He expects business spending to start recovering by the fourth quarter, however, with “a new wave of capital spending” coming in 2003 as the recovery gains traction.

Another reason for caution on tech shares is that the stocks’ valuations quickly became expensive again with the fourth-quarter rally, Applegate said.

Shares of computer networker Cisco Systems (CSCO), at $16.15 on Friday, are priced at 35 times analysts’ average earnings estimate of 47 cents a share for the fiscal year ending in July 2003, according to earnings-tracker Thomson Financial/IBES.

Cisco--which rallied from $12 in September to $21 in January, then fell as low as $14.24 by late February--may be a good example of what investors will face in 2002, some pros say: a market best suited for traders, and likely to test the patience of long-term investors.

Doll said 2002 could be “a year of incredibly frustrating rotation” as investors search for market leadership. In a volatile market, the “buy-low/sell-high approach” can produce bigger gains than buy-and-hold, Doll said.

Although playing the trading game always looks easier in retrospect, more investors may have to be willing to part with shares that have scored big gains in favor of issues that have potential but haven’t yet begun to move, some experts say.

Doll said he has taken some profits in consumer-related stocks such as Nike Inc. (NKE) and Whirlpool, for example, which both climbed more than 50% in the last 12 months, and added to financial and energy holdings on recent dips.