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MAY 29, 2006
Stocks: Where's The Top? Sure, stocks are high. And our examination of them from three angles -- the economy, valuations, and technical analysis -- shows they're likely to stay aloft Only 30 out of thousands of stocks make up the Dow Jones industrial average, but in the public's mind it is the stock market. So when the Dow flirts with a new high, people take notice. On May 10, the index closed to 11,643, a shade below its all-time high of 11,723, only to give back 223 points in the next four sessions. 
As the Dow reaches for the heights, investors face that age-old conundrum: Is the stock market hitting a ceiling or building a new floor? Our analysis shows the market has sturdy economic and valuation underpinnings, but the technicians who study trading patterns and volume expect headwinds. In other words, use pullbacks as buying opportunities. A GROWTH SPURT THAT WON'T QUIT A strong run by the U.S. economy is helping to push equities back near record levels. While some economists, including Federal Reserve Chairman Ben Bernanke, expect growth will begin to decelerate over the course of the year, indicators both in the U.S and abroad remain bullish for stocks. The U.S. economy is expected to grow by 3.4% this year, according to Blue Chip Economic Indicators, down a touch from the 3.5% rise in 2005. That's pretty good, given a cooling housing market and sky-high energy prices. The economy will keep up its good performance because key fundamentals for solid growth are still in place: Businesses are drawing on their hoards of cash to hire more workers, buy new equipment, and build new plants. Equities stand to benefit from all this activity, especially the stocks of capital-goods makers. Production of business equipment is growing at a double-digit pace, and overall business investment should post another strong year. Idle production capacity in the U.S. is quickly disappearing, and robust global economic growth, forecast to remain above 4.6% this year and next by the International Monetary Fund, has sparked an upswing in capital spending across the globe. Plus, if the dollar were to fall from here, it would mean all U.S. multinationals will see a boost in earnings from overseas operations. All that growth raises concerns. Demand for oil and metals is not easing. Indeed, U.S. consumption of gasoline has exceeded year-ago levels despite the price surge. That will likely keep commodity prices elevated and inflation concerns front and center. Tighter labor markets are also producing faster wage growth. The combination has the potential to eat into corporate earnings, especially in a more competitive global economy. So far, U.S. companies have overcome higher costs by getting more productivity out of their workers, but that will be hard to sustain if hiring and wages follow current trends. Average hourly wages rose 3.8% from a year ago in April, the fastest pace since mid-2001. Companies that don't find a way to raise prices may see margins slip. Recent inflation figures show that businesses may be gaining some pricing power -- one reason why the Fed isn't ruling out more rate hikes. Investors are concerned the Fed could go too far with them and hurt economic prospects. But economists still believe the central bank will pause soon, if just temporarily, to assess the effects of prior hikes. If and when the Fed does take a break, it would be yet another reason to expect stocks to keep on climbing. By James Mehring VALUATION HEADROOM Stocks have rallied this year, but valuations, especially for the biggest companies, remain modest. The Standard & Poor's (MHP ) 500-stock index is trading at a price-earnings ratio of 14.4, based on analysts' estimates of earnings over the next 12 months, says Edward Yardeni, chief investment strategist at Oak Associates. That's near the average of 15 over the past 58 years. Valuations for small-cap stocks, which have outpaced blue chips for six years, are slightly above their historic averages. Higher stock prices are not a given, but the potential is there. For starters, corporate earnings have a lot of momentum. For 2006's first quarter, companies in the S&P 500 posted a profit gain of 14%, even in the face of higher interest rates and energy costs. That marked the 11th straight quarter of double-digit profit gains, and it handily beat analysts' expectations. For the rest of the year, forecasts call for more double-digit profit gains for big caps. Even though interest rates have been climbing, stocks remain a better buy than bonds. How so? Go back to the 14.4 p-e on stocks. Then, take the yield on the 10-year Treasury, 5.14%, and divide that into 1. That gives you 19.5, a p-e equivalent for bonds. The upshot: Stocks are 26% undervalued relative to bonds. Of course, a quick runup in interest rates or a collapse in corporate profits will close that gap, too, but neither is expected. "There's much more potential upside to investing in U.S. equities than in Treasuries," says David Dropsey, research analyst at Thomson Financial (TOC ). Should stocks dip, there's cash to support them. Private-equity firms, which raised a record $100 billion in 2005, stand ready to scoop up bargains. Many companies have the wherewithal to support their stocks, too. Dividend increases are up and payouts are expected to grow 12% in 2006, says Standard & Poor's. Some $90 billion in stock buybacks were completed in the first quarter, about 10% ahead of last year's pace and more than twice as much as during the same period in 2004. During the last bull market, buybacks were often done to back stock options, not to reduce the number of shares. Today, companies have curtailed option grants, thanks to new accounting rules that require the expensing of options. So money spent on buybacks is reducing the number of outstanding shares, says Sam Stovall, chief investment strategist at S&P. By Anne Tergesen DOUBTS FROM THE NUMBER CRUNCHERS For stock market technicians, how many shares trade is as important as the price at which they sell. Jeffrey Hirsch, editor of the Stock Trader's Almanac, is not impressed with recent trading volumes, which have been more robust on down days than on up days. When the Dow Jones industrial average rallied 139 points on May 5, trading volume on the New York Stock Exchange was 1.67 billion shares. But when the market fell nearly 260 points on May 11 and 12, roughly 1.8 billion shares changed hands each day. "That's not overly bullish," says Hirsch, who thinks the Dow will fall at least 20% in the coming months. Looking at the number of stocks advancing and declining, Louise Yamada of Louise Yamada Technical Research Advisors, is also cautious. She points to the 10-day advance-decline data that show fewer NYSE stocks gaining ground vs. those falling back, a trend that has gone on all year. If this continues, she says, it could portend a serious decline. Another concern: 72% of the NYSE stocks are trading above their average price for the past 200 days. Isn't that a plus? Not so, says David Kovacs, senior portfolio manager at Turner Investment Partners. He says it's the sign of a mature bull market. Kovacs says he'd be more bullish if the number were closer to 40%, as it was last October. The stock market is up more than 10% since then. This bearishness is not unusual since technicians focus on short-term movements, unlike most investors. Looking further ahead, even the bearish Hirsch is not all that glum: "We expect 2007 is going to be a good year." By Lauren Young 
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