Bear market seems unlikely as anxieties rattle investors

Traders

Traders work on the floor of the New York Stock Exchange May 23. (BRENDAN MCDERMID / REUTERS)

Investors can't shake the jitters.

After a brief calm in the stock market Monday in the wake of last week's sharp sell-off, investors turned squeamish about stocks again Tuesday and took cover in Treasury bonds. At one point, selling drove the Dow Jones industrial average down about 190 points, though the market recovered somewhat at the end, closing down 139 points for the day.

Since a high of 17,138 on July 16, the Dow has lost more than 700 points, or about 4.1 percent. The ongoing selling has fueled speculation that the market could be in the midst of a correction, a decline of 10 percent or more, as stocks are sold temporarily to bring prices down to levels that better match likely profit potential for the near future.

While corrections sometimes occur after too much enthusiasm, most analysts don't think this will turn into a bear market, or a lengthy decline of 20 percent or more. Typically, bear markets are set off by recessions, not pricey stock markets or geopolitical shocks. And the U.S. economy is showing strength, not signs of a recession.

"Three-fourths of 10 percent-plus corrections happened around recessions," said Deutsche Bank strategist Binky Chadha in a report to clients. "They almost never occurred when unemployment was falling."

Geopolitics seemed to be the driving factor for the sudden sell-off that began shortly after noon Tuesday. The Dow began sliding sharply after a report from a Polish official who suggested Russia was building up troops on Ukraine's border to possibly stage an invasion.

But as in last week's scare, it wasn't simply geopolitics alone driving nervousness. It is the recent strong economic data that has investors on edge because they know a stronger economy might cause the Federal Reserve to let interest rates start climbing from zero and sour investors on stocks.

Typically, when rates climb, investors become more cautious about stocks and risky corporate bonds because company profits and the economy can be slowed by more expensive borrowing costs. And in the current environment, investors are particularly on edge because the low-rate environment is so unique. Low rates have helped drive stocks up about 200 percent since early 2009, including 36 percent over the past two years. Even as some analysts have noted that stocks were pricey, and potentially vulnerable to a decline, investors have continued to pour money into stocks because holding cash or Treasury bonds paid so little.

With higher rates in the future, bonds and even cash may attract investors — causing investors to worry about stock market declines.

Most analysts don't think interest rates will begin rising until next summer. But economic data released Tuesday was so strong that it gave credence to the thinking that the Federal Reserve might let interest rates rise more quickly.

The Institute of Supply Management Non-Manufacturing Index, which measures the service sector of the U.S. economy, hit an eight-year high.

"Activity improved in every sector, apart from utilities," said Paul Dales, economist for Capital Economics. "We are encouraged by the widespread strengthening in demand."

Services — which involve everything from construction to education and real estate — make up about two-thirds of the U.S. economy. In addition, another report Tuesday showed factory orders stronger than anticipated.

Investors also have seen strength in second-quarter earnings reports showing that companies seem to be generating profit growth of about 10 percent and revenue growth of almost 5 percent. Analysts have argued that there is no need for a correction in stock prices with profits that strong.

Yet, Gluskin Sheff economist David Rosenberg suggests profit growth may be misleading and that the realization might be behind some of the recent stock market jitters. He notes that JPMorgan research shows 60 percent of Standard & Poor's 500 earnings growth derived from companies buying back their shares. Only 40 percent is because of organic earnings growth, or the type of growth that shows prosperous conditions.

Rosenberg says under those conditions, stocks are actually pricier than they look, or priced at 20 times organic earnings rather than those influenced by removing shares of stock from the market.

"It is this valuation extreme that likely has many equity investors a tad unnerved for the time being," he said in a report to clients. To work out the extremes and bring stock prices down to 16 times organic earnings, he said a market correction could approach 20 percent.

Still, in a note to clients Tuesday, Goldman Sachs strategist David Kostin said he is expecting the Standard & Poor's 500 to gain 8 percent over the next 12 months. He points out that stocks generally perform well in the year before the Federal Reserve starts raising rates, but then they decline.

Even with the Fed raising rates, he expects stocks to perform better than bonds between now and 2018. He anticipates 6 percent annual returns in the stock market over that period and just 1 percent for 10-year Treasury bonds.

gmarksjarvis@tribune.com

Twitter @gailmarksjarvis

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