What a Week: Market Ends Quarter Positively, but Unsteady as She Goes - TheStreet

SAN FRANCISCO -- For the second consecutive week, broader averages packed up their troubles in their old kit bag and smiled, smiled, smiled while blue-chips lagged. The troubles included a potentially disappointing quarter-point rate cut by the

Fed

, intermittent trading glitches, and another round of warnings, most notably from

Merck

(MRK) - Get Report

and

Merrill Lynch

(MER)

.

For the week, the

Dow Jones Industrial Average

fell 1% and the

S&P 500

was down fractionally, while the

Nasdaq Composite

gained 6.2% and the

Russell 2000

rose 4.9%. (The Comp's week included a bizarre extra hour, as

trading was extended Friday to make up for earlier system outages.)

The week provided a microcosm for the just-completed second quarter, during which major equity averages ended higher for the quarter. Despite concerns about the economy and expectations that earnings will be the

weakest since 1991, the Dow rose 6.3% in the quarter, the S&P gained 5.5%, the Comp rose 17.4% and the Russell 2000 climbed 13.8%.

Still, major averages remain down year to date: the Dow by 2.6%, the S&P by 7.1% and the Comp by 12%. However, the Russell 2000 is up 6% year to date, reflecting the ongoing outperformance of small- and mid-cap stocks.

The market's recent gains reflect expectations that Fed rate cuts will revive the economy and that major averages bottomed in late March/early April -- expectations that are not mutually exclusive.

The

Court of Appeals for the District of Columbia

overturning a ruling to break up Microsoft also provided a psycological boost, and shares of the software giant rose 1.5% for the week.

Hope on the economic front arrived this week in the form of stronger-than-expected reports on durable goods and consumer confidence, as well as continued evidence of a strong housing market. On Friday, the

University of Michigan

reported a second consecutive rise in its monthly index of consumer confidence, while the

Chicago Purchasing Managers

report bested expectations.

Also Friday, first-quarter

GDP

growth was lowered to a scant 1.2% from 1.3% in the

Commerce Department's

"final" revision. Nevertheless, the aforementioned data and the Fed's

decision Wednesday to lower rates by 25 basis points vs. 50 (or more) contributed to rising hopes that the economy is on the mend.

Such sentiment benefited equities this week but bonds faltered. Fixed-income securities generally fare better in periods of economic weakness because they are most sensitive to inflation. Inflation fears have receded as energy prices have dipped and the dollar has remained strong. But some fixed-income participants still fret over inflationary pressures in the pipeline.

Bonds also were hurt this week by rising concerns about the durability of the budget surplus. With the economy slowing, some bond investors fret that tax receipts will decline just ahead of forthcoming tax cuts. Additionally, given the balance of power in Washington, any spending submitted by the White House, say on defense, is likely to be met by other quid pro quo spending requests by congressional

Democrats

.

For the week, yields on the benchmark 10-year Treasury (which move in the opposite direction of its price) rose 16 basis points. For the quarter, they rose 48 basis points. Yields on the two-year note, which most closely track the fed funds rate, rose three basis points for the week and six basis points for the quarter.

Bonds also suffered because of the renewed interest in equities as some investors switched from bonds to stocks.

Quarter by Quarter

Action this past week and quarter have reinvigorated some investors' hopes, although it'll be interesting to see whether the situation Friday on Nasdaq damages confidence. Even before the snafu, skepticism remained a mainstay on Wall Street.

"I think we came through the market and economic declines in good shape, in the sense things could have been worse," said Stanley Nabi, managing director at

Credit Suisse Asset Management

said of the quarter. "Having said that, I think during the last few months the market rebound has set another problem for us -- one of valuation."

Based on

First Call

estimates, the S&P 500 is trading with a price-to-earnings ratio of about 22 times reported 2000 earnings, 23 times expected 2001 results, and 20.5 times expected 2002 results. While down from peak P/E levels of early 2000, that is not cheap by historic standards. "Old Economy stocks are no longer cheap," Nabi said, declaring that the "valuation disparity" created during the tech-stock bubble has largely been closed.

"The market is trading at very high levels relative to anticipation of a recovery next year

and this will restrain stock prices from making a major move in next six to 12 months," he continued, predicting earnings will continue to deteriorate at least through the third quarter. Nabi also believes consensus expectations for S&P earnings of $53.12 this year and $59.77 in 2002 are too optimistic. He's using $49 for this year and $54 for next.

"I don't see how some leading strategists can postulate a 20% increase

in earnings next year," he said. "It just isn't going to come about" because the economic recovery will be slow, the consumer is tapped out and foreign economies are weakening.

Having said that, Nabi is not predicting disaster and believes major averages have seen their lows. It's just that "there is very little room on the upside for stocks" based on current valuations, he said, calling small-cap value the "only particularly cheap sector."

Nabi, who manages about $4 billion in value funds for Credit Suisse Asset Management, cited

Lancaster Colony

(LANC) - Get Report

,

Allmerica Financial

(AFC) - Get Report

,

Banta

(BN)

,

Meredith

(MDP) - Get Report

,

Constellation Brands

(STZ) - Get Report

and

Tupperware

(TUP) - Get Report

as examples of small-cap stocks that are attractive on a valuation basis. His firm is long each of the aforementioned.

The other group he remains bullish on is energy, despite recent woes, which he predicts will likely last through the summer. On a cash-flow basis, "energy is the cheapest major sector in the market by far," the veteran market player said. "Come the fall, you'll probably see oil prices stabilize not far below recent levels, which will be very good for companies to produce solid earnings."

Value investors will start returning to the group as those fundamentals unfold, Nabi said, declaring an intent to add to existing positions in anticipation. He recommended starting with service stocks that have been battered most in recent weeks, including

Transocean Sedco Forex

(RIG) - Get Report

,

Nabors Industries

(NBR) - Get Report

and

Helmerich & Payne

(HP) - Get Report

.

Aaron L. Task writes daily for TheStreet.com. In keeping with TSC's editorial policy, he doesn't own or short individual stocks, although he owns stock in TheStreet.com. He also doesn't invest in hedge funds or other private investment partnerships. He invites you to send your feedback to

Aaron L. Task.