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Riding the Recovery

Stocks struggle to keep momentum despite optimism about economy.


The recession of 2001 has given way to the recovery of 2002. And a recovering economy almost always has meant that stocks are the place to be.

After the devastating market decline of 2000 and 2001, that's a welcome thought for many investors, of course.

But in the first quarter, Wall Street didn't quite play along with the historical script. Stocks struggled to a mixed finish, unable to extend the powerful rally of the fourth quarter that followed the post-Sept. 11 dive in prices.

The blue-chip Standard & Poor's 500 index closed virtually unchanged for the quarter ended March 28, though counting dividend income, the index's "total return" was a positive 0.3%.

The average domestic stock mutual fund likewise posted a minuscule positive return of 0.4%, according to fund-tracker Morningstar Inc.

There were plenty of bright spots in the market in the quarter, including "value"-oriented shares, natural resources stocks and many foreign issues.

But the first week of the second quarter brought a fresh sell-off market-wide, raising new concerns that the next major turn on Wall Street's roller coaster won't be to the upside.

"On 'the Street' there's a pretty good battle going on between the optimists and the pessimists," said Ed Keon, investment strategist at Prudential Securities in New York. "We fall on the optimists' side, but the pessimists have a good story as well: Their point is that the economic downturn was not that strong, so this recovery may not be much either."

Lehman Bros. strategist Jeffrey Applegate also is an optimist, relatively speaking: He expects the rebounding economy to lift corporate profits this year, and believes share prices will advance as well. His year-end price target of 1,350 for the S&P 500 would mean a 20% gain from the index's Friday close.

"At this point in the economic cycle, stocks should outperform bonds," he said. But the market's fourth-quarter rally priced in a healthy portion of this year's corporate profit recovery, he said. So stocks may not see the kind of gains this year that were typical after other recessions.

In fact, the market's advance from its recession lows reached Sept. 21 has been modest, compared with the rallies following previous recession lows.

The S&P 500 is up 16.2% since Sept. 21, and the Nasdaq composite index is up 24.4%.

By contrast, approximately 28 weeks after the market's recession lows of 1990, the S&P was up 28.4% and the Nasdaq index was up 48.9%.

Experts say investors have some good reasons for being cautious about pushing share prices higher, despite the economy's apparent emergence from recession.


Waiting for Rebound in Corporate Profits

One key question is whether corporate earnings--the fundamental underpinning for stock prices--will rebound strongly in the second half of the year. Brokerage analysts are setting the target high for the third and fourth quarters, predicting a 38% year-over-year climb in earnings for the S&P 500 companies in the period, said Robert Doll, chief investment officer at Merrill Lynch's asset management division in New York.

Doll and others note that advance corporate warnings about first-quarter results have been lighter than usual, which suggests that the reports will be on target or better than expected.

But a wave of warnings last week from the software industry didn't help investors' confidence, and contributed to the week's 4.1% drop in the tech-heavy Nasdaq composite index. Year-to-date the index is down 9.3%, after surging 30% in the fourth quarter.

If investors begin to question whether robust revenue and profit growth is possible later in the year, the market could struggle from here, with the major indexes notching gains in the high single digits--at best--for the year, Doll said.

One reason for caution is that consumer spending never withered in the 2001 recession, making it unlikely that a dramatic surge in spending will supercharge the economy, he said. What's more, many analysts don't believe that corporate capital spending will turn up significantly this year.

Along with the possibility of a choppy or muted earnings recovery, steep stock valuations are a key concern on Wall Street.

"By historical standards stocks are still fairly expensive," Keon said, noting that the S&P 500 trades for a price-to-earnings ratio of about 23 based on this year's profit estimates, compared with its historical average P/E of about 15.

Valuations may limit the market's upside, Keon said, because there is arguably little room for P/E ratios to expand.

In past economic recoveries, the market got a lift not only from rising corporate earnings but also because investors were willing to pay higher prices relative to earnings. Because the average P/E already is high, that P/E expansion may not happen this time.

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