Market Rally Still Has Legs

"We've seen the most stimulative policies than any government has ever tried to do -- 13 interest-rate cuts from the Federal Reserve, two massive tax cuts and the federal budget surplus going from a surplus to a $500 billion deficit," said Ray Devoe, author of the Devoe Report newsletter. "I'm less bearish than I've been for three years, but I'm not exactly bullish," said Devoe, who expects the Dow to remain in a trading range of 9000 "plus or minus 15%."

Thanks in part to the stimulus efforts of the Fed and the Bush administration, the economy and corporate earnings showed strength not seen since the late 1990s. Meanwhile, the stock market rallied as many predicted, but the leadership of that rally caught many by surprise.

Of the 27 S&P 500 components to post gains of 100% or more through Dec. 8, 15 were tech stocks -- among them Avaya(AV Quote) (335% gain), PMC-Sierra(PMCS Quote) (218% gain), Yahoo!(YHOO Quote) (154% gain) and Sanmina(SANM Quote) (up 145%). Few expect the richly valued tech sector to lead in 2004.

"One of the things that surprised me this year was the market's leadership: It was lower-quality, nondividend-paying stocks," said (EHSTX Quote)Eaton Vance Large Cap Value manager Michael Mach, who forecast that 2003 would be a strong year. "Maybe investors sensed the opportunity to buy beaten-down stocks, but we're starting to see a move into higher-quality names."

Fred Hickey, editor of the High-Tech Strategist newsletter in Nashua, N.H., agreed that the "stunning surprise" of this year was the outside performance of the most speculative tech companies. "One minute nanotech was hot, then China dot-coms, then semiconductors -- this looks like the bubble reinflated," he said.

While tech's gaudy returns may have grabbed the headlines, the rally has been remarkably broad-based. The S&P 500's Web site lists the year-to-date performance of 10 sectors and 114 subsectors according to the Global Industry Classification Standard, or GICS. Of the 114 subsectors, only five had negative year-to-date returns through Dec. 5 -- only one of which, photographic products, featured a decline greater than 10%. Meanwhile, the top five subsectors had returns in excess of 90%.

In June, TheStreet.com discussed why the latest rally was different from previous bear-market rallies, and why it may continue. At that time, the key to the rally's sustainability was seeing the market's prediction for a recovery turn up in economic data and earnings.

By and large, the earnings recovery has materialized. In the third quarter of 2003, 64% of S&P 500 companies posted earnings that beat expectations, up from the long-term average of 58%. And early signals from the fourth quarter suggest the earnings recovery will continue apace. Of the fourth-quarter preannouncements through Dec. 8, 35% of companies raised guidance -- typically during "earnings warnings" season, only 21% of preannouncements raise guidance, according to Thomson First Call's Gint Rimas.

Meanwhile, the economy has revived as well, as evidenced by the 8.2% rise in the GDP during the third quarter. While Devoe notes that about 2.5 percentage points of that increase was due to tax cuts and low-financing incentives by automakers, many expect the impressive growth to continue.

"We may not see China-like GDP growth as we did in the third quarter, but we anticipate real GDP growth of 4% in 2004," said Bruce Wilcox, chairman of New York investment firm Cumberland Associates.

Market watchers were mixed about whether the recovery would remain a "jobless" recovery. "I think the employment picture gets a lot better -- in every other recovery in history, we see employment lag at first," said James Altucher, a partner at hedge fund Subway Capital and a contributor to Street Insight, TheStreet.com's sibling publication. Altucher said the increase in average hours worked signals that "employers are trying to squeeze as much as possible out of their employees before hiring more. The hiring decisions come next, and the economy follows." Eaton Vance's Mach and others anticipate renewed hiring activity as well.