Grim Best-Case for Stocks: Finish Year Flat

A crisis of confidence in Corporate America slammed U.S. stocks to the mat in the first half of the year. The best-case scenario now is grim: an unchanged stock market for the full year.

To break even, stocks in the benchmark Standard & Poor's 500 index have to climb more than 15 percent. That was easy in the go-go days of the late 1990s, but tough now as the U.S. dollar plummets, technology company profits slide further, and more reports surface of corporate malfeasance -- the latest a shocking admission by telecom provider WorldCom Inc. it overstated results by $3.8 billion.

"There's a one-in-five chance we'll end in positive territory for the S&P 500," said Darryl Mikami, a fund manager for Putnam Investments. "There's just too much negative feeling out there."

Investors have been turning their backs on Wall Street amid accounting scandals and charges of corporate mismanagement at former highflyers like energy trader Enron and conglomerate Tyco International . The latest roundhouse punch from WorldCom sent the technology-packed Nasdaq composite index on Wednesday to touch a 3-1/2-year low.

If stocks close down for 2002, it'll be the first three-year losing streak for the major indices since 1941.

To be sure, there are some bright spots. The U.S. Federal Reserve kept interest rates at 40-year lows on Wednesday afternoon, and likely won't raise them until at least November. And profits for S&P 500 companies are forecast to rise 14 percent this year -- although investors have been burned before in betting on a profit recovery.

Investors can avoid more disappointment by skirting tech stocks, which took the market down in the first place, and buying shares of companies that benefit from early stages of an economic upturn, Wall Street strategists say. They also advise investors to keep buying shares of small and medium sized companies, which have held up better than those of companies included in gauges like the S&P 500.

"Data points suggest there'll be no upturn (for tech) until sometime in 2003 and valuations need to come down some more," said Bruce Simon, chief investment officer at Glenmede Trust Co., which oversees $16 billion. "We favor companies that have a cyclical bent, that have more leverage to a global economic recovery which is still on track."

But distrust and fear will dampen buying into large companies, especially after Tyco's former chief was slapped with criminal charges and the conglomerate's books were probed for possible accounting errors.

"It's a one-step-forward, half-step-back kind of market," said Gil Knight, fund manager at Allied Investment Advisors, which oversees $11 billion. "There are a lot of confidence worries."


The Fed last year lowered short-term interest rates to a 40-year low of 1.75 percent to shore up the slumping economy. The tactic worked, not only in spurring business development but also in getting consumers to refinance mortgages at lower rates and spend their money on new cars and clothes.

The economy has picked up, too. The U.S. gross domestic product grew at a 5.6 percent rate in the first quarter, according to economists polled by Reuters. GDP is a measure of goods and services produced within the United States.

In addition, U.S. consumer confidence is still above levels seen at the early stages of an economic recovery. The strength suggests consumer spending, which powers two-thirds of U.S. economic activity, will stay solid, economists and analysts said.

Adding to optimism, gains in small and mid-cap stocks help underpin the market. About 298 stocks rose in the first five months of the year, while 212 declined, according to market research firm Standard & Poor's. Last year, breadth was negative, with 213 stocks gaining and 256 falling.

"There will definitely be better breadth in the market because of the underperformance of major-cap stocks," said Robert Cohen, head trader at Credit Suisse First Boston. "We'll probably see a net gain for smaller-cap stocks."

And finally, earnings growth is widely expected to pick up from last year's dismal slide of 17.3 percent, according to analysts surveyed by Thomson First Call.

"The most powerful force is the turnaround in earnings per share," said Ned Riley, chief investment strategist for State Street Global Advisors, which oversees $40 billion. "This will be a year of a quiet but strong earnings recovery beginning in the third quarter."

But could be that enough to yank indexes higher for the year? "If we were to finish anywhere near the highs of the year, people would be very surprised," said Robert Arancio, head of Nasdaq trading for Lehman Brothers.


One reason the market is in the doldrums is a drastic slowdown in capital spending.

For example, global sales of chipmaking equipment tumbled almost 42 percent in April from a year earlier, according to industry group Semiconductor Equipment and Materials International.

"Companies we talk to in the consumer sector are seeing better orders, but capital spending is brain dead," said Knight.

Another worry is the outlook for the weakening U.S. dollar. The greenback has tumbled to two-year lows as the stock market has weakened. If the dollar falls more, foreign investors will be even less willing to hold U.S. stocks or U.S. cash as they look to stronger growth elsewhere.

Investors also are struggling with deep distrust of corporate management and balance sheets after a slew of companies have restated earlier results.

Adding to confusion, S&P has clamped down on companies that exclude one-time charges from earnings reports, in a bid to have corporate results better reflect true business conditions. But other earnings tracking services such as First Call, as well as companies, have kept their reporting system intact.

General Electric Co. , for example, reported operating earnings of $1.42 a share last year. But according to S&P's new calculations, its actual earnings were 22 percent less after stripping out pension gains, the cost of stock option grants and gains from asset sales.

Finally, violence in the Middle East, worries of U.S. military action against Iraq and fears of more terror attacks in the United States are weighing on stocks.

"There are a lot of unknowns and the market's not cheap," said Marian Kessler, a fund manager for Rutherford Investment Management in Portland, Oregon. "People are willing to step up and buy, but there hasn't been enough good news."