Broad Decline in Stocks Seen as Unlikely

For three straight weeks the stock market has lost ground as concern over higher interest rates, rising oil prices and Mideast tensions has overshadowed robust corporate profits and growing evidence of a solid economic expansion.

The Standard & Poor’s 500-stock index, in the black just a few weeks ago, is now down 1.5% on the year.

Other market barometers are faring worse. The Dow Jones industrial average, which ended at 10,012.87 on Friday, has dropped 4.2% since Dec. 31.

The technology-heavy Nasdaq composite index has sunk 5% this year.

Investors are starting to ask whether the bull market that ran through most of 2003 was a one-year wonder. At a minimum, some strategists warn, stocks could continue to struggle with so much uncertainty in the air.

Yet most investment pros say a broad, deep decline is unlikely from current levels. The optimistic view is that a strong economy, an improving labor market and healthy corporate profits will underpin share prices.

Still, some experts say that if the rally resumes, it is most likely to be of the selective, “stock-pickers’-market” variety rather than a broad upswing.

“Last year was similar to 1999, when a rising tide lifted all boats, and it almost hurt your performance if you paid attention to the fundamentals,” said Russ Koesterich, U.S. equity strategist at State Street Global Markets in Boston.

His view is that “we’re returning to more normal times, where top companies with strong balance sheets will do best.”

With the economy rebounding, most analysts are no longer wondering whether the Federal Reserve will hike interest rates when it meets next month; the question now is whether the increase will exceed the quarter percentage point that had been widely anticipated.

In times of rising rates, investors’ natural tendency is to shift toward large, high-quality companies and away from more speculative names, some Wall Street pros say.

Koesterich said he was urging clients to position themselves “defensively,” favoring big names in sectors like drugs and consumer staples, which are considered relatively stable and largely immune from interest rate pressures.

In the consumer-staples group, personal-care products maker Gillette Co. is up 13% this year. Avon Products Inc. is up 25%.

John Snider, manager of the TCW Galileo Large Cap Value mutual fund in Los Angeles, is taking the opposite tack: He said though his portfolio was fairly balanced, he and co-manager Tom McKissick had placed bigger wagers on the energy, basic-materials and industrial sectors, where companies could benefit from a continuing economic expansion.

“We still believe in the economically sensitive bet, even in a higher interest rate environment,” Snider said. “Indeed, the Fed is going to be raising rates because the economy is doing quite well.”

Even so, many basic-materials and heavy-industry shares have pulled back in recent weeks.

A Merrill Lynch index of 27 such stocks, including Alcoa Inc., Dow Chemical Co. and International Paper Co., is down 10.5% year to date.

Like Koesterich, Allan Rudnick, who runs the Phoenix-Kayne Rising Dividends fund in Los Angeles, said he believed that “high-quality companies with clean balance sheets” were in the best position to flourish on Wall Street.

Companies with lower credit ratings were the star performers in 2003, as the market snapped back from its three-year slump with a vengeance and investors increased their appetite for risk.

But many of the firms whose stocks rose the most last year also tend to have higher price-to-earnings ratios. And as interest rates rise, P/E ratios usually contract as investors become more averse to risk, Rudnick said.

Thus, steeply valued stocks and companies with heavy debt loads are most vulnerable to higher rates, he said.

Rudnick’s focus on high-quality companies has led him to Pfizer Inc., Johnson & Johnson and Eli Lilly & Co. in the healthcare sector.

Among industrials, Illinois Tool Works Inc. and label maker Avery Dennison Corp. get his nod.

Rudnick also likes conglomerate General Electric Co., although he concedes that it may come under “short-term pressure” because of its financial services unit. Investors might punish that sector in response to rate hikes.

Ken Tower, chief market strategist at Princeton, N.J.-based brokerage CyberTrader Inc., said he liked two sectors: technology, which has paced most market rallies in recent years, and energy.

In the tech sector, many Internet-related shares have held up relatively well this year. Yahoo Inc. is up 20% since Dec. 31. Some wireless-technology shares also have fared well.

In the energy sector, an index of 13 major oil and gas stocks, including Exxon Mobil Corp. and Occidental Petroleum Corp., is up 8.3% this year. But recent gains have been tempered by a widespread belief that oil prices in the $40-a-barrel range are only temporary.

If that consensus changes and high energy prices are seen on Wall Street as a longer-term reality, the sector could soar to new heights, Tower said.

He called pharmaceuticals a “wild card,” saying the sector’s fate could sway with the presidential race. If Democrat John Kerry gains the upper hand, investors might shy away from drug stocks, fearing government regulation that could eat into profits, Tower said. If President Bush looks headed to victory, the sector could see a relief rally, he said.

Overall, the stock market might end 2004 fairly flat, just as in 1994, when the S&P; 500 dipped 1.5% as the Fed was aggressively tightening credit, strategists said.

TCW’s Snider said that though he remained guardedly optimistic about the economy, the bearish camp on Wall Street believes Fed Chairman Alan Greenspan “has been waiting for so long to raise rates that he is really behind the curve.” Those analysts fear the Fed now is likely to act too decisively, inadvertently quashing the economic recovery.

The Fed has held its key short-term rate at a generational low of 1% since June, when it was trimmed from 1.25% in the last of a series of cuts.

Another potential risk for the market is that Wall Street analysts, who are busily raising their corporate earnings targets for 2004, might be “behind the curve” as well, said Joe Cooper, senior analyst at earnings tracker Thomson First Call in Boston.

Though first-quarter earnings for the S&P; 500 companies are expected to grow 27.1% from a year earlier once all of the firms have reported, the fourth quarter’s year-over-year growth of 28.3% is sure to be the peak of the current growth cycle, Cooper said.

For the year, analysts on average expect S&P; 500 profits to rise 17%.

“Now the question is whether the analysts will end up having to shave, rather than raise, their expectations for 2004,” Cooper said. “They always extrapolate the current trends, but with higher interest rates coming, there is sure to be an inflection point -- it’s just a question of when.”

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Diverse leadership

Though major stock market indexes are in the red year to date -- the Standard & Poor’s 500 index is down 1.5% -- many individual issues are holding on to sharp gains. The winners are an eclectic mix, reinforcing the idea that investors are getting pickier in trying to identify stocks that can fare well in a strong economy facing rising interest rates.

Biggest stock sector winners in the Standard & Poor’s 500 index, year to date

*--* Wireless services +26.1% Internet retailing +22.2 Healthcare supplies +21.9 Internet software +19.6 Oil and gas refining +18.7 Employment services +17.2 Personal-care products +16.3 Motorcycles +15.6 Healthcare distributors +14.6 Agricultural chemicals +14.4

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Source: Bloomberg News