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Rallying to a Rousing 1st-Half Finish

Growing Optimism, Rising Earnings Fuel Stock Gains Worldwide

July 01, 1999|TOM PETRUNO

The Fed gave investors a gift they weren't expecting on Wednesday, and that was excuse enough for Wall Street to end a spectacular first half with a flourish.

The Dow Jones industrial average rocketed 155.45 points, or 1.4%, to close at 10,970.80, lifting its gain for the half to 19.5%.

The Nasdaq composite closed the half with an even bigger bang, soaring 1.7% to a record 2,686.12--topping the previous high of 2,652.05 set on April 26. The blue-chip Standard & Poor's 500 index also hit a record high.

For equity markets worldwide, 1999 so far has been a great party almost everywhere--reflecting a growing belief that the global economy is more likely to improve than regress from here.

Brazil's stock market leaped 71% in local currency terms in the half. South Korea soared 57% and Japan shot up 27%.

And on Wednesday, the Fed appeared to remove the most serious issue dogging U.S. stock prices in recent months: The threat of a potential sequence of interest rate increases, which some Fed governors had hinted might be necessary to combat a largely unseen inflation threat.

The Fed's decision to raise its benchmark short-term rate from 4.75% to 5% was expected, but its concurrent decision to remove its "bias" toward additional rate increases was a shocker--sparking a wave of euphoria that drove stocks up and bond yields down.

"What's not to like?" asked an ebullient Phil Orlando, investment chief at Value Line Asset Management in New York, who predicted the Dow is headed for 11,500 soon.

But bearish investors naturally could find something not to like. Some said that the Fed's now "neutral" status on rates just risks putting markets back on pins and needles if U.S. economic data show renewed strength and investors start wondering whether the Fed will change its mind again.

For bond investors, who've suffered as yields have surged this year, "this [Fed move] is not a good thing," argued Randy Merk of American Century funds.

Yields did plunge on Wednesday, in part reflecting a rush by "short-sellers" to cover bets that the trend in rates would be higher. The bellwether 30-year Treasury bond yield ended at 5.97%, down from 6.06% on Tuesday--though still way up from 5.1% at the start of the year.

But Merk and other bond managers worry that the Fed's decision will simply make stocks seem even more invincible, fueling a new equity market rally that bonds can't compete with.

"Why would [the Fed] want to juice this equity market?" Merk asked, given that the central bank is well known to be concerned that stock capital gains, real and imagined, are driving many U.S. consumers' voracious spending.

In other words, if the goal is to slow the economy, the Fed's measly quarter-point rate hike may easily be overwhelmed by the "wealth effect" benefit provided by stocks.

But until and if the bond market has another panic attack about the economy and the Fed, many Wall Street pros say, stock markets worldwide probably have a green light to add on to their first-half gains--despite what are historically high share valuations almost everywhere.

For better or worse the equity market is, as it has been for most of this decade, the only game in town for most investors.

Yet there also is a solid underpinning to this year's rally: a rebound in corporate earnings in the United States and the expectation of earnings growth in recovering Asia and in other regions as economies improve.

Second-quarter year-over-year earnings growth for blue-chip U.S. companies is expected to be in double digits again, after a 10.5% rise in the first quarter, according to earnings tracker First Call.

With inflation still low, "it would be odd if it [stocks' rally this year] hadn't happened," given the earnings improvement, argues Jeffery Applegate, investment strategist at Lehman Bros. in New York.

The bears argue that higher interest rates ought to negate the effect of better earnings. But reality is that most investors aren't making a choice between stocks and bonds with their money. If stocks look better on their own terms, that's reason enough for many people to buy.

Even so, higher interest rates did appear to take a toll on the most stratospherically valued stocks in recent months. Internet-related shares and many consumer growth stocks tumbled in the second quarter.

Among the biggest blue-chip stock-sector losers in the second quarter were drug shares, down 13% on average, and restaurant shares, down 11%.

Much of the money that left those issues, however, simply looked for a new home in other stocks. That contributed to one of the most important U.S. market trends of the quarter: a broadening of the market's advance, especially into small- and mid-size stocks, and into "cyclical" heavy-industry names that should benefit from a stronger global economy.

S&P's index of 600 smaller stocks leaped 15.2% in the second quarter, more than double the 6.7% rise in the blue-chip S&P 500 index.

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