A Market Bound by Fear

Brokers across the country report great reluctance among investors to buy.
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The paranoia that has swept Wall Street this month is starting to take on an ominous color to some market players, going from the justifiable trepidation that usually greets a new monetary cycle, to a more engulfing stasis that could last the year.

"There is a general fear of what to do," says a top Citigroup Smith Barney broker. "There's a paralysis among a lot of clients about what to buy."

A Wachovia Securities broker says he's seeing a similar hesitancy from his customers, many of whom are still licking their wounds from the brutal bear market, even after last year's big 25% rebound in the

S&P 500

and nearly 50% gain in the

Nasdaq

.

"My customers are just afraid," says the Wachovia broker. "A lot of it has to do with people still being battered and bruised from the bear market."

One indicator of the grim mood is the recent surge of money into the "bear funds" offered by Rydex Investments. Total assets in the funds, which are popular with traders and retail investors who like to make quick market bets, now stand at $1.9 billion, up from about $1.3 billion at the beginning of the year, according to the market psychology firm Sentimentrader.com.

Of course, investors have a lot to be worried about these days, what with rising interest rates, soaring gas prices and the war in Iraq. And some of the recent selling on Wall Street may just reflect an opportunity by nervous investors and traders to lock in profits made last year.

Knox Fuqua, a money manager with AAM Investments, says it's pretty clear the stock market got ahead of itself. He wouldn't be surprised by a 5% to 10% decline in the major indices before investors feel comfortable again.

Still, Fuqua says he also senses an underlying pessimism on Wall Street that belies the strong first-quarter earnings posted by most companies. He says there was a lot of talk about the shaky state of investor psychology during a recent investment conference he attended.

That unease is borne out by the recent survey numbers from

Investors Intelligence

. The technical analysis firm on Wednesday reported that 25.7% of financial advisers it polled were in the bearish camp, up from 23.7% last week. Meanwhile, the number of bulls declined to 44.6% from 46.4%. The number of financial experts expecting a market correction -- traditionally a decline of 10% -- fell slightly to 29.7% from last week's 29.9%.

In fact, a number of recent opinion polls have displayed a surprising disconnect between the signs of an improving economy and the public's perception of a recovery.

A recent Gallup Poll, for instance, found that half of the people questioned say the economy is "getting worse," despite the Labor Department reporting that the nation created roughly 600,000 new jobs the past two months. A Gallup commentator says the gap reflects wealthy Americans getting more optimistic about the future, while the less-affluent grow pessimistic.

One category of rich people who are worried are hedge fund managers, normally Wall Street's most sophisticated traders.

April was a bad month for hedge funds and May is looking like another downer. As of Tuesday, the Hedge Fund Research Global Hedge Fund Index was down 1% in May, after posting a 1.23% decline in April. Worse, the pain in the hedge fund world is being felt across the board in May with all types of hedge funds -- merger arbitrage funds, distressed securities, event-driven and market neutral -- in the red.

A trader with a Midwestern hedge fund says he's seeing an extreme amount of pessimism in the nation's heartland and believes that's dampening investor enthusiasm. He says investors don't feel like buying stocks when they are worrying about rising gas prices and what appears to be a growing quagmire in Iraq.

One thing that worries this trader is that if the selling on Wall Street doesn't abate, it could put the kibosh on what has been a long overdue revival in corporate deal-making. A drop in stock prices may make it difficult for companies to use their shares to fund purchases.

The market downturn already may be hurting the merger market. Thomson Financial reports that this month, a higher percentage of buyers have turned to cash to make purchases. So far, 64% of the dollar amount of all the corporate deals announced in the U.S. in May have been in cash, compared to 47% for the entire year.

Others, meanwhile, say the sour mood on Wall Street could deepen as we get closer to the November election, especially if the Republican administration is in trouble.

As

TheStreet.com

has reported before, Wall Street investment banks are betting heavily on a Bush victory, giving most of their campaign contributions to the incumbent. Wall Street bankers are backing Bush because they generally favor the administration's low-tax policies and fear Massachusetts Sen. John Kerry, the presumptive Democrat nominee, will reverse some of those tax cuts, including the one slashing the tax on stock dividends.

Earlier this year, when a Bush re-election seemed a certainty, the market was trading higher and adding to last year's robust gains. But some note that the recent selloff in the market gained steam following the release of several polls showing Bush's approval rating dropping to an all-time low.

"The market is starting to factor in the higher probability of Bush losing," says a Florida hedge fund manager. "And whenever there is that kind of uncertainty, that's not good for stocks."

Indeed, from presidential politics to the economy to Iraq, the one thing that isn't in short supply these days is uncertainty.