Rally boosts stocks and bonds, but will it last? - SMall Business Financial Advisor

Nation's Business, May, 1995 by Randy Myers

Scaling the "wall of worry"; extra health coverage at the top; shopping around for lower-cost long-distance time.

Is the party over? The stock market sprinted to record highs in the first three months of 1995, and the bond market staged an impressive rally of its own following a disastrous year in 1994. With the average stock mutual fund up 7.16 percent for the first quarter (see table) and the average bond fund up 3.97 percent, a prudent investor might be sorely tempted to cash out.

But that would be a mistake if the history of investor psychology is any guide. While the markets' recent fireworks have many investors worried that prices moved too high too fast, that same nervousness suggests the markets still have room to run. Veteran analysts call it "climbing the wall of worry"

"When you move to new highs the way we've been doing, you usually see optimistic speculation really bubbling over," explains Don Hays, director of investment strategy for Wheat First Butcher Singer, an investment banking firm in Richmond, Va. "We've had virtually none of that; instead we've had intense fear the whole way."

Absent such fear, according to the wall-of-worry theory, investors will bid stock and bond prices far above their intrinsic value and make a downturn inevitable. A healthy nervousness keeps prices in check and precludes a crash. Accordingly, market experts surveyed by Nation's Business suggest that while this rally may pause to catch its breath sometime soon, there's no evidence yet that investors ought to be bailing out of stocks and bonds.

Of course, no bull market goes straight up, and Hays says he wouldn't be surprised if stock prices were to pull back by 3 to 6 percent sometime before the second quarter ends on June 30, probably on renewed fears about the economy

Attractive Cyclicals

Where will the best opportunities be found? Many investment pros are looking to cyclical issues--those dependent on a strong economy--which generally lagged in the last quarter amid concerns that the economy might slow down too quickly in 1995 after a healthy 4 percent gain, as measured by gross domestic product, in 1994. But with a growing consensus that the economy will instead enjoy moderate but sustained growth through 1995--the elusive "soft-landing" sought by the Federal Reserve Board--many of these companies' stocks might rebound.

"A lot of these cyclicals seem to us to be a lot more attractive now," says James Kennedy, director of research for T. Rowe Price & Associates Inc., Baltimore, one of the nation's largest mutual-fund operators. "In the early part of an economic recovery, supply and demand are far apart, but late in the cycle, supply and demand tighten up, and that's when producers [of cyclical goods] get pricing power."

Funds that invest in foreign stocks also were beaten down badly in the first quarter. The Latin American fund, for example, dropped by 30 percent. Not surprisingly, investment pros aren't promoting them as aggressively as cyclical stocks. Instead, they're suggesting merely that the funds may represent a reasonable opportunity for long-term investors. For the near term, it would seem, the real party is staying at home.

What could slow the U.S. stock market? If investors are complacent about anything and are therefore chipping away at the wall of worry, it's the idea that a soft landing for the economy is in the bag. If investors change their minds, the stock market could be shaken.

Another wild card is the U.S. dollar, which hit a post-World War II low against the Japanese yen and the German mark at the end of the first quarter. A weak dollar helps U.S. companies that do much of their business overseas because their exports become less expensive in those markets and because the companies benefit from currency translations on their foreign profits.

But a weak dollar also makes imported goods more expensive here at home, increasing inflation pressures and thereby threatening the economy.

The dollar has fallen 30 percent against the yen since President Clinton took office, but one-third of that decline has come in the past three months alone.

Thus far this year, the Fed has resisted the temptation to raise interest rates to try to buttress the dollar. But there's no guarantee it won't take that action in the future, and higher rates again could threaten the economy.

If the dollar does rally, multinational companies that have benefited from the weak greenback could be hurt.

One prop supporting the stock market is the growing propensity of Americans to save for retirement. Despite the market's lackluster performance in 1994, investors poured more than $119 billion into stock funds last year and continued to add money in the first quarter of 1995.

A Mixed Picture For Bonds

Bond funds haven't enjoyed the same support. Investors withdrew about $43 billion from them last year, and only this February did these funds begin to register the first net inflow of money since March 1994.

The turnabout followed a rally in the bond market, where prices began climbing in late November and continued to do so through the first quarter. Over that period, the yield on the Treasury's 30-year bond fell to about 7.4 percent from just under 8.2 percent; yields on 10-year Treasuries fell to about 7.1 percent from 8.1 percent; and yields on high-quality 30-year municipal bonds fell to about 6.1 percent from just under 7.3 percent. (Bond yields, or interest rates, move inversely to bond prices.)