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Things fell apart, markets shrugged

Published Sep. 28, 2005

In case you missed it, Russia defaulted on its debt, the House impeached President Clinton and corporate profit growth slowed last year. That sounds like a recipe for stock market disaster, but 1998 showed once again that logic and gravity don't always apply on Wall Street.

In spite of bad news and a midsummer sell-off, big blue-chip stocks turned in an unprecedented fourth consecutive year of double-digit returns. Before the current streak, the Dow Jones Industrial Average had never put together more than two big years in a row. Now traders are aiming for five.

The Dow finished 1998 up 16.10 percent, while the Standard & Poor's 500 Index did even better, returning 26.67 percent. Technology stocks soared and those with an Internet connection blasted into the stratosphere, reaching prices out of proportion with their size and profitability.

Odds are that 1999 will not bring a repeat, but that is what the oddsmakers said about 1998. One of these years, the theory goes, stocks must return to "normal," which in historical terms is average gains between 10 percent and 11 percent. Besides that, high stock prices and a near-perfect economic environment leave little room for improvement.

"I don't see a disaster for 1999, but if it can't get any better, then it can only get worse," said Gerald Perritt, a Largo money manager who publishes the Mutual Fund Letter and runs the Perritt Microcap Opportunities Fund.

He said stocks have been supported by falling interest rates and inflation along with a flood of investor money _ trends that cannot be sustained forever. Neither interest rates nor oil prices are likely to hit zero, and investors already have begun cutting back on their purchases of stock mutual funds.

Good times may not last forever, but predicting when they will end is no cinch.

Last year investors were willing to brush aside concerns about political scandal at home, economic problems overseas and even the usually reliable "Super Bowl indicator," which says the market is headed down any year a former American Football League team such as the Denver Broncos takes home the Lombardi Trophy.

However, it wasn't a smooth ride. The Dow rose or fell more than 200 points on 16 trading days last year and 100-point moves became routine. The most jarring experience was a 512-point drop Aug. 31, which took the market average to 7,539.07. That was a 19.3 percent fall from its July peak _ enough for some market experts to proclaim a bear market, albeit a brief one.

The Dow climbed to a new high of 9,374.27 Thanksgiving week and finished the year not far below it, at 9,181.43. The Standard & Poor's 500 index kept on going, hitting its peak of 1,241.81 just last week and closing the year at 1,229.23. The technology-heavy Nasdaq Composite Index closed at 2,192.69, up 39.63 percent.

Unfortunately for many investors, a lot of stocks missed out on those big gains. The average U.S. stock mutual fund only did half as well as the S&P. Many middle-sized and smaller companies went down with the rest of the market last summer and never fully recovered from the hit. The Russell 2000 Index, a small-stock indicator, finished the year down 3.44 percent.

"The gap in performance between the supercap stocks and the rest of the market is greater than I've ever seen it," said Howard Ward, manager of the Gabelli Growth Fund in New York.

There are lots of reasons for that, starting with the fact that big stocks are easier to trade and thus more appealing to money managers and foreign investors who put a premium on liquidity. Many of these giant companies also earned investor confidence through their performance.

"The profit growth of those supercap companies has been terrific," Ward said. "Earnings are in fact growing for companies like Microsoft, Cisco, IBM and Home Depot and they are driving their stock prices. Those companies are pulling the market averages up with them despite the fact that a lot of stocks have gone down."

The S&P Index gives the most weight to the biggest stocks based on market value (number of shares outstanding multiplied by price) _ companies such as General Electric and Microsoft. The Dow gives the most weight to the highest-price stocks _ companies such as IBM and Merck.

These top stocks now trade at very high prices in relationship to their earnings. Microsoft, for example, trades at about 75 times the past 12 months' earnings. Some Internet stocks trade at hundreds of times earnings. America Online, which was just added to the S&P Index, has a market value greater than that of Walt Disney Co.

"Valuations are through the roof," said Ralph Bloch, chief market analyst at Raymond James & Associate Inc. in St. Petersburg. For the market to be healthy, he says its advance needs to broaden to include more of the stocks that have been left behind. Otherwise, it is in serious danger of toppling, he said.

Many small stocks now trade at bargain prices, which gives their supporters hope that 1999 will be the year to reverse more than a decade of underperformance.

"If they were to take off, the advance would be huge because money would shift (out of blue chips)," money manager Perritt said. He said many small-cap funds are now smaller than they were a year ago because prices have fallen and investors have deserted them. That could signal that they've hit bottom.

However, small-caps offer no haven for investors worried about market volatility. If stocks go down, the little ones will not be immune to the market's woes; in fact they could fare worse. And if the economy does slow, investors may prefer the security of big-name companies.

"If the economy turns bad, the current valuation gap between the relatively few "glamour stocks' and the rest of the marketplace should further increase, leading to an enormous gap between the haves and the have-nots," predicted John Rekenthaler, research director at Morningstar Inc., the Chicago investment information firm. "If, on the other hand, economic worries were to dissipate, small-company and other high-risk investments could enjoy unusually large gains."

But many investors are counting on rising earnings to justify the blue chips' high prices going into 1999, which could be a shaky presumption.

"Our biggest concern is slowing corporate earnings," said Tampa money manager Dee S. Howland, president of Howland & Associates. "Many large company stocks are still at too-high valuations, at price-earnings ratios not supportable by earnings growth."

The underlying question is what will happen to the U.S. economy. The current economic expansion, which dates to March 1991, is already the longest in U.S. peacetime history. In an era of global interdependence, it faces a real threat from economic woes in other countries, including important trading partners such as Japan and Canada.

"The troubles overseas are much worse than most Americans appreciate," said George Fischer, manager of the Fidelity Spartan Municipal Income Fund in Boston. "I don't think people quite understand what an engine of growth Asia was and how that engine has sputtered out. Latin America and Russia are also in tough shape. I don't think we can remain immune from that much longer."

From Fischer's perspective, that makes bonds an attractive investment _ particularly municipal bonds, which offer tax-exempt yields close to those on taxable Treasury bonds.

"The next 12 months will be the most challenging time that investors have experienced in years," predicted Clearwater analyst J. Michael Pinson of "Dow 7,400 to 7,600 would not be shocking at all."

Nevertheless, he is optimistic that the Dow will climb to new highs in the new year _ mainly because of the Federal Reserve Board's investor-friendly stance, which could include another drop in short-term interest rates in the spring. Pinson said he expects some sectors, such as computer manufacturing, technology, electronics, home building and home finance, to do particularly well.

"As long as earnings continue to go up and interest rates don't get out of hand and start going up, we could continue in a relatively stable environment for stocks," said University of South Florida economics professor Steven Bolten. "But I really do doubt we can get interest rates down and earnings high enough to get another year of 20 percent gains."

Among the potential threats on the horizon are the growing imbalance of trade and Europe's conversion to the euro, which could prompt some foreign countries to switch their currency reserves from dollars to euros. That would mean money flowing out of dollar-denominated investments.

There also is the looming Year 2000 computer problem, which the stock market doesn't seem to be worrying much about.

As the year unfolds, we will be hearing a lot more about the possibility that a big percentage of the world's computers will go haywire when the next New Year dawns.

"Due to a tremendous amount of testing and spending on updating chips and codes, we doubt there will be major disruptions," said Ann F. Cody, an analyst at Hilliard Lyons in Louisville, Ky. "However, markets may become more volatile as 1999 draws to a close."

Of course, if no meltdown occurs, relieved investors could give stocks a boost in January 2000.

Cody said the real problems for the market could turn out to be things nobody knows about or is thinking about yet. In 1998, we had megamergers, Internet frenzy, the bombing of Iraq and a capital immobilized by Bill and Monica. Who knows what 1999 will bring?

"The United States weathered some heavy economic storms this past year and our nation displayed amazing resilience," she said. "But we suspect there may be occasions in the future when the resilience is more sluggish and when resolutions to surprises could take longer. Whether a military, financial or political event occurs, we believe markets will react increasingly swiftly, and that pricing volatility will persist."

What's an investor to do in this environment?

"The best advice is to be cautiously diversified among asset classes," USF's Bolten said. "If you're a 15- to 20-year investor, it doesn't make a bit of difference anyway."

Money that will be needed in a few years does not belong in stocks anyway. For long-term investments, such as saving for retirement, most financial advisers recommend ignoring the market's ups and downs while continuing to invest regularly. American Express Financial Advisors in Minneapolis goes a step further.

"Begin a new hobby," suggested Jan Blakeley Holman, vice president of investment services. She advocates pastimes that require intense focus, such as making your own wooden jigsaw puzzles. "There's no question that hobbies offer a sure-fire method for forgetting that your portfolio, and possibly your net worth, might have declined by 10, 20 or 30 percent."

The drive for five

The Dow Jones Industrial Average has put together an unprecedented string of double-digit returns in the 1990s. Can blue chips finish the decade with a flourish?

Year Closing average % gain from previous year

1990 2,633.66 -4.34%

1991 3,168.80 +20.32%

1992 3,301.80 +4.18%

1993 3,754.10 +13.72%

1994 3,834.44 +2.14%

1995 5,117.12 +33.45%

1996 6,448.27 +26.01%

1997 7,908.25 +22.64%

1998 9,181.43 +16.10%