Market Miracle: Apocalypse Not Now

A funny thing happened on the way to the abyss.

Early-morning indications pointed to a wicked session amid revelations of a huge accounting scandal at WorldCom (WCOM).

After some steep initial losses, major averages fought back to mere modest declines by midday and spent much of the afternoon clawing back toward break-even, which they briefly surmounted before ending with near-insignificant changes.

After trading as low as 8936.74 early on, its first trade under 9000 since Oct. 5, the Dow Jones Industrial Average closed down a minuscule 0.1% to 9120.11. The S&P 500 ended down -- 0.3% to 973.53 -- but up from its early low of 952.92, its lowest intraday level since Sept. 21. The Nasdaq Composite finished up 0.4% to 1429.33 after having traded as low as 1375.53, below its Sept. 21 intraday low of 1387.06.

On a day of dramatic developments and myriad crosscurrents -- including WorldCom's implosion, the FOMC meeting, Adelphia's (ADLAC) bankruptcy filing, Micron's (MU) miss -- it was hard to pinpoint what turned the market.

Some suggested technical factors, specifically the S&P's ability to remain above its Sept. 21 intraday low of 944.75 (although retesting, even breaking, that level seems inevitable, as I wrote at midday.)

"When we tested the Sept. 21 lows -- give or take -- and didn't go breaking through, people were viewing it as fairly constructive," said Michael Driscoll, director of listed trading at Bear Stearns.

Driscoll also suggested the market did what it's wont to do: Frustrate as many participants as possible. "We came in this morning and people were expecting Armageddon," he said. "Everyone is waiting for a massive volume, cataclysmic down 600 points, [and] it's not that easy."

In Big Board trading, a heavy but not overwhelming 2 billion shares traded, while declining stocks bested advancers 18 to 13. Over 1.8 billion shares traded over the counter, where declines led 10 to 7.

Looking ahead, the trader suggested that with so many participants (understandably) eager to fade any rallies, "what screws up the most people is a few days of rally that everyone shorts, and it keeps going," he said. "I do think we're getting close to some kind of rally."

His expectation for continued gains is also based on a view that sentiment is overwhelmingly negative and that "every company is [not] engaged in criminal activity," as some investors are starting to suspect.

Model of Attractiveness

Another rationale for stocks' advance was that they became attractive relative to Treasuries, which rallied sharply again despite finishing off their best levels of the session. The price of the benchmark 10-year Treasury note rose 19/32 to 101 1/32, its yield falling to 4.74%.

The S&P 500 was trading at a price-to-earnings ratio of 40 heading into this week, based on Standard & Poor's reported "core" earnings, but a growing number of market participants suggested stocks looked appealing vs. fixed-income -- even before today's wild swings.

"My dividend discount model shows the market to be 24% undervalued," Byron Wien, chief U.S. investment strategist at Morgan Stanley, commented yesterday. "We are in an emotional period when quantitative tools don't always work well, but sentiment is profoundly negative and valuations are attractive."

In it simplest form, Wien's model examines the relationship between the 10-year Treasury's yield and the S&P 500's earnings yield, which is its expected earnings divided by price. (A more formal definition of a dividend discount model is the present value of future dividends, according to -- yes -- Dividenddiscountmodel.com.)

Wien, who routinely warned the market was overvalued in the late 1990s, was unavailable for additional comment. But he is not the only strategist-type citing various valuation models as favoring equities. As reported Monday, Tobias Levkovich, equity strategist at Salomon Smith Barney, believes stocks are attractive on the basis of S&P's earnings yield, which was 8.81% heading into this week (vs. 4.76% for the 10-year yield), according to Barron's. Separately, Don Hays of Hays Advisory Group and Lehman Brothers' chief strategist Jeffrey Applegate made similar comments.

The point is not the spotty -- to be kind -- track record of some of those erstwhile gurus, but that many institutional investors employ these valuation models. If the models suggested equities were attractive vs. Treasuries heading into this week, they were doing so more dramatically early today, as 10-year yields fell to the lowest levels since early December.

The Man Behind the Curtain

The other major catalyst cited by market participants was the Federal Reserve, which -- as was widely expected -- left the fed funds rate unchanged at 1.75% today and its risk assessment at "balanced."

In the wake of this morning's better-than-expected durable goods and new-home sales reports, some expected the Fed to make more optimistic comments about the economy. Still others thought the Fed might make some overt allusions to WorldCom and related issues, in order to quell investors' jitters.

Both those camps were left wanting by the Fed's statement, but what the central bankers didn't say was perhaps most important, according to Peter E. Kretzmer, senior economist at Banc of America Securities.

"On a day like today, with WorldCom, the dollar and God knows what else, maybe some thought the Fed might need to talk about market stability," Kretzmer mused, suggesting that by not going down that road, the Fed's statement was reassuring.

"The fact they didn't indicates these are the ups and downs of the market, and they expect these factors to be subsidiary over time to the performance of the economy and don't expect that to be overly affected by these other factors," he said.

Of course, others believe the Fed's support was far more direct, and there was the inevitable talk of the so-called plunge protection team. As I've written previously, whether the Fed engages in these "rescue operations" is less important than the perception among many investors that it surely does.

Perhaps what's most noteworthy about today's session is that the Fed didn't really need to rescue anything, as selling wasn't overwhelmingly heavy even early on, and market participants found their own reasons to buy shares (see above). Today's action also suggests the greatest fear among many participants remains that of missing out on the next rally, a sentiment traditionally not found at the end of bear markets.

>To order reprints of this article, click here: Reprints