Market could be bear in disguise

By Adam Shell and Matt Krantz, USA TODAY

A message of hope has been emanating from Wall Street: Stocks are at clearance-sale prices and aren't likely to fall much more, so now is the time to buy.

The Sept. 11 attacks triggered the stock market's worst weekly slide since the Great Depression. And that plunge has prompted a chorus of bullish predictions suggesting that if the bear market isn't already over, it soon will be. Consider:

• Abby Joseph Cohen, Goldman Sachs' top strategist and longtime bull, told the investment bank's deep-pocketed clients: "It is time to buy stocks."
• Barron's, the normally skeptical financial newspaper, put a snorting bull gripping an American flag on its cover. The cover blurb: "It's time to buy stocks."
• Three brokerages — First Union Securities, A.G. Edwards and Banc of America Securities — joined Goldman Sachs in increasing the weighting of stocks in their model portfolios. The range: 70% to 80%.

So far, at least, they look pretty smart. The market snapped back last week from its post-attack free-fall in fine fashion. At Friday's close, the Standard & Poor's 500 was up 8% from its Sept. 21 low, the Dow Jones industrials up 7% and the Nasdaq 5%.

But market historians and bears warn brief rallies and go-go bulls are exactly what suck unsuspecting investors into a market about to crumble even more. Even if stocks don't disintegrate further, it could take decades to repair the damage.

"When people say no one on Wall Street has seen a bear market, this is what they mean," says Gibbons Burke of MarketHistory.com. "We're not even close to bottoms you can see."

Even with last week's gains, the damage this year has been horrific. The Nasdaq is starting the fourth quarter today down 39.3% — its worst performance ever for the first 9 months of a year and equal to its loss for all of 2000. The S&P's 21.2% drop is its fourth worst for the first three quarters. The 18.0% Dow drop is its ninth worst.

And some analysts are warning that the renewed cheerleading for stocks last week showed that the bear still has plenty of kick left. They view the boundless optimism as a contrarian indicator: If everyone is sure stocks are ready to rise, the opposite is much more likely to occur.

Running with the herd has backfired before. For the past 18 months, the bulls on Wall Street have been unsuccessful at picking a market bottom. They could be wrong again.

"Wall Street is biased. It is not objective," says Woody Dorsey, president of Market Semiotics. "Strategists want the market to go up. They have a bet on that. Wall Street has failed to recognize since Day 1 that the scale of this correction is much bigger than people thought."

Indeed, at a time when Wall Street gurus are downplaying the risks in the stock market, a plethora of worries and risks remains.

Economists say odds of a global recession are rising. Another terrorist strike in the USA can't be ruled out. How and when the U.S. will retaliate and how effective it will be is unknown.

And although the start of the bombing of Iraq in the Persian Gulf War actually helped trigger the start of the 1990s bull market, analysts caution against expecting the same result this time. Profits at U.S. companies are shrinking. And consumers aren't brimming with confidence.

That's a lot of bad news that could weigh down stocks for an extended period. Unlike the bulls, bears aren't convinced all of the negative headlines are already reflected in lower stock prices. It will take time for investors to properly revalue stocks after such an extraordinary event as the terrorist attacks, they say.

"I don't know what numbers to plug into my Excel spreadsheet that will account for two jetliners ramming into the twin towers. You can't quantify that type of curve ball," says Mark Minervini, president of Quantech Research.

And there is no hot new sector or technology to take the place of smashed Internet and tech stocks, says Bryan Taylor, president of Global Financial Data. "We need a new, big idea," he says.

Complacency vs. panic

That's why skeptics worry that the bulls' rallying cry to snap up beaten-down stocks may be premature. Investors who make big commitments to stocks now, they say, risk adding to losing positions.

"It's like the home team falling further and further behind, yet the crowd's roar gets louder and louder," says Todd Salamone, research chief at Schaeffer's Investment Research. "Complacency — not panic — still reigns. That makes the market vulnerable."

Market bottoms, experts say, are not made when many on Wall Street are saying nice things about stocks. A true floor that provides lasting support for stock prices probably won't occur until investors are fed up and completely despise stocks. Magazine covers that warn of financial Armageddon, not riches, are the stuff of what true bottoms are made.

That's what happened before the biggest bull market in U.S. history, which began its two-decade climb after stocks hit bottom in August 1982. Three years earlier, after a decade in which stock returns lagged gains notched by bonds, gold, diamonds and real estate, Business Week ran its legendary cover story, "The Death of Equities," in its Aug. 13, 1979, issue. Ditto Aug. 17, 1998, when stocks were swooning and Business Week ran another bleak cover, "How worried should you be?" Stocks rallied then, too.

But this time, amid the most challenging market environment in almost 30 years, things are different. Today, the optimistic outlook for stocks is the opposite of the angst and pessimism found at prior market bottoms. Barron's recent cover story imploring people to buy stocks despite an impending war and recession is a prime example. What it does is increase rather than decrease complacency.

"I've never seen investors take it on the chin so well," Minervini says. "The Nasdaq's plunge is a Depression-type decline, yet people are pretty relaxed. I would have expected a bear — not a bull — on Barron's cover and lots of doom and gloom."

In fact, as of Wednesday, 51.1% of individual investors said they're bullish, vs. only 22.2% who said they're bearish, according to a survey by the American Association of Individual Investors.

The bulls' case

While the market's recent declines may mark a bottom, it's probably not the bottom, bears say.

The bulls don't see it that way. They say it's too difficult to pick a bottom and that current prices are compelling enough to start putting money back to work. The odds of making money in stocks, they say, are pretty good for investors who invest now, when it appears the world is coming to an end.

The market and economy will get a big boost from government rescue packages, interest rate cuts from the Federal Reserve and tax cuts. And the past three bear markets have ended in October, Taylor says. "We're getting close to the bottom. October is typically the turnaround month," he says.

Another argument bulls use is that the market reflects a worst-case scenario and prices are at such compelling valuations that they simply can't be ignored.

After upping the firm's stock allocation to 80% from 70% Tuesday, A.G. Edwards' Mark Keller said that current stock prices already have taken into account a deep recession. Even if that worst-case scenario occurs, however, he doubts stocks will tank.

"The pessimism that stock prices reflected in the aftermath of the Sept. 11 attacks reminded us of the emotional extremes that have characterized past market lows," Keller says. "We doubt prices will decline further."

Money manager Jim O'Shaughnessy, CEO of Netfolio, agrees that stocks are priced to buy in the wake of the terrorist-induced sell-off. "This is a once-in-a-decade buying opportunity," he says.

However, valuations still remain far above historical levels. Since 1926, the S&P 500's average price-earnings ratio based on trailing 12-month earnings is 15.2, according to Ned Davis Research. The current P-E is 28.2. So if the P-E were to revert to historical norms, the S&P 500 would need to drop to 560, a 46% drop from Friday's close of 1041.

The bears stress that while P-Es are a useful gauge to get a sense of what people are willing to pay for stocks, they are not a good tool for timing the market. Markets can stay undervalued and overvalued for long periods. Some experts say there's a chance the S&P 500 can go down an additional 10% to 15% before bottoming out and mounting a new bull run.

What to do?

So what's an investor to do? Those looking to put fresh money to work should tread carefully, says Ross Margolies, manager of Salomon Bros. Capital fund. For starters, don't buy anything until companies report their third-quarter earnings. "Wait until all the bad news is out," he says.

If a quality stock you've been eyeing takes another big hit, you'll be able to buy it at a cheaper price. If bad news strikes and the stock holds up, you'll know all the bad news is priced in. "It's not going to kill you to wait a few weeks," Margolies says. "You should be shopping for opportunities."