Are We In for a Seven-Year Rally?

Is the worst bear market since the Great Depression finally over?

It sure looks that way. Defying critics, skeptics and conventional wisdom, the U.S. stock market has emerged from the agonizing, slow-motion crash of 2000-02 to advance 25% in the past 12 months -- putting it on track to record the first positive year of the new millennium.

Popular companies such as Intel ( INTC) and Amazon.com ( AMZN) have done even better than that, respectively zooming 104% and 201% in the past year as investors have cheered their brilliant comebacks from the depths of despair.

Overall, stocks of the new-school technology, biotech and retail companies that make up the Nasdaq 100 have more than doubled the return of the broad market -- scorching naysayers with a 55% gain since October 2002.

If returns of this magnitude have taken you by surprise, welcome to the club.

Thousands of households are still sitting on billions of dollars in cash that they withdrew from stock accounts during the two years of decline, swearing that they would never bet their hard-earned dollars on flimsy slips of paper again. And now they are wondering whether crooked pros on Wall Street have played them for fools once again, enticing them into the market with big gains just as prices are about to drop again.

So is this unexpected gift about to vanish in a cloud of smoke, or is it really safe to own stocks again? To answer, you need to understand why the rally happened in the first place.

Day in and day out, there are five different factors that govern the performance of stocks: the general mood of investors; business expectations for the near future; interpretations of the recent past; the supply and demand of stock and cash; and competition from other types of investments. And as fate would have it, all five have favored stocks in 2003.

  • Better mood. A year ago, investors were freaked out about the rising threat of war, orange terror threats, a worsening economy and the stymied hunt for Osama bin Laden. Fear climaxed in the second week of March, just before the start of the war in Iraq, as stock prices fell to their lowest level of the year amid a general revulsion for risk-taking. At present, while combat continues in Iraq and the economy isn't perfect, the country's overall psyche has improved enormously, and we're ready to take risks again.
  • Earnings have improved. Companies ranging from homebuilders to coffee sellers have reported recently that business is much better now than last year. Just last week, teen-oriented retail chains like Hot Topic (HOTT) and Pacific Sunwear (PSUN) reported sizable month-over-month increases in comparable-store sales. Surprised investors bid their shares up.
  • CEOs have regained confidence. Professional investors look at least six months into the future when they make stock buy-and-sell decisions. Many skeptical pros are preparing to hear negative guidance on fourth-quarter and 2004 business prospects when companies report third-quarter earnings this month. If chief executives' guidance is rosier than the pros expect, investors will bid prices higher -- possibly explosively. It might well happen. Business confidence surveys published by the Conference Board, Duke University and the Manufacturing Alliance/MAPI all reported in the past two weeks that chief executives feel more positively about economic conditions now than at any time in the past three years.
  • Little competition from bonds. Stocks are always in a battle for investors' affections with risk-free rates of return from U.S. government bonds. When bonds yield 6% or more, they become extremely attractive to professionals. But for the past year-and-a-half, the Federal Reserve has done everything in its power to drive Treasury yields down as low as 3% to 4%, fostering a stronger demand for stocks.
  • Supply of stock lower; amount of capital higher. Bear-market bankruptcies severely cut the number of stocks available in the marketplace, marginally increasing the value of the remaining shares. And mergers continue to diminish the supply of stock available to investors at the same time that few initial public offerings are being made to make more stock available. Meanwhile, the Federal Reserve, the Bush administration and Congress have pumped more dollars into Americans' hands through a variety of means, including tax rebates and an increase in the money supply. Excess capital often finds its way into the stock market, boosting prices.
  • Big-Caps Try to Earn Investor Confidence

    Many large companies have done their part to encourage investors to feel increasingly confident about their own prospects by innovating mightily during the recent downturn. New products generate new sales and income at the margins, and make investors want to participate in the companies' success. Two examples:

  • Starbucks (SBUX) shares are up 48% this year. Credit their success, in part, to their smart decision to increase sales during the summer with a new line of iced, shaken sweet tea and coffee drinks. Beverages like the Vanilla Cr¿me Frappuccino also broadened the company's appeal to noncoffee drinkers, such as the children of their regular customers. Starbucks' revenue in the second quarter of this fiscal year jumped to $954 million, from $783 million the previous year.
  • Intel (INTC) shares are up 96% this year. Credit that success, in part, to the company's decision to shift focus from sales of semiconductors that run desktop personal computers to sales of a new breed of semiconductors that power access to wireless broadband networks. Intel launched its new Centrino line of Wi-Fi chips in March with a massive advertising campaign that has yielded big dividends. Sales in its fiscal second quarter hit $6.8 billion, up from $6.3 billion the previous year. Earnings, meanwhile, doubled from 7 cents per share to 14 cents.
  • What We Need Now

    The good tidings can continue, resulting in higher stock prices a year from now, if a few things go right:

  • Employment, capital spending and inventories must continue to grow, making the economic recovery so self-sustaining that it doesn't require further fiscal or monetary stimuli from the government. Pay special attention to improvements in unemployment and personal income, as nothing juices the economy more than an increased number of workers making more money. A jobless recovery is one thing, but a job-loss recovery won't cut it. Consumers panicky about their pay prospects will stop spending and abort the recovery.
  • Demand in every region of the world -- especially Latin America, Japan, Europe and China -- must improve. At this point, all but Europe are on track.
  • With the economy operating below its potential, inflation needs to remain muted. Oil has to stay beneath $30 a barrel, and interest rates need to stay fairly low. Low rates will allow homebuilding and home refinancing to stay on track.
  • An improving economy is needed to lift tax revenue, narrowing the federal and state budget deficits. Diminishing fears of an out-of-control deficit opens the door to the extension of tax cuts in 2004-05, particularly if President Bush is re-elected.
  • A growing appetite for U.S. goods among the emerging middle classes of China and India could give our economy a "boom" look -- vindicating free-trade advocates and producing winners all around.
  • Analysts at investment research firm ISI Group point out that the longest economic recoveries in the past have started out the slowest. If things go well, the U.S. might not face another recession until at least 2010. And seven years of expansion would be very kind to stocks, making the 25%-plus advance of the past year look like a nice start, not a false start.

    Jon D. Markman is senior investment strategist and portfolio manager at Pinnacle Investment Advisors. While he cannot provide personalized investment advice or recommendations, he welcomes column critiques and comments at jdm@oddpost.com. At the time of publication, Markman owned or controlled shares in Pacific Sunwear and Starbucks.

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