Worried Wall Street Pricing In Wild Scenarios

After the beating suffered by the stock market over the last six months, the mood on Wall Street is so gloomy that people are speculating on just how much lower it will go.

Investors are pricing in three scenarios: a sub-par economy, weak corporate earnings and more accounting land mines.

The worst thing that could happen is Wall Street's mess gets messier and the flow of cash tilts overwhelmingly to the safe haven of bonds and money markets.

This would set the stage for an horrific market correction, something worse than the one that pushed down the Nasdaq by more than 20 percent in the second quarter.

The Street's confidence didn't get a shot in the arm this week as the technology-heavy Nasdaq opened the third quarter with an uninspiring slump to a 5-year low. The Standard & Poor's 500 index dropped to its lowest since 1998 and the Dow Jones industrial average flirted with its September lows.

The market gained at the end of the week, but it will take many more sessions of higher closes before investors are convinced the downward trend is changing.

Despite the bear market, a lot of people are still loading up on U.S. stock funds, which gained on net $4.8 billion in May. It was the eighth consecutive month of increases even as the average stock fund fell 12.2 percent in the second quarter. More remarkably, it is the first time since December, 1975 that the average stock fund has had a such a long losing streak.

What's gives?

Here's a quick snapshot why stocks continue to suck in money while they are still performing poorly.

Typically, more money flows into the market in the fourth quarter of the previous year and the trend picks up in the new year through mid-April. Then it tapers off by midyear. The pattern, by the way, is a pretty good indicator of how to play the market.

The seasonality of money flows this year could be very important in determining the direction of the market, which needs a constant new source of cash to keep it from stumbling. It's based on the premise that in order for stocks to go up, the market needs more buyers than sellers. In other words, if investors rush to the exit, the selloff would be magnified by a shortage of buyers to smooth out its descent.

Most investors no longer have an appetite for risks after agonizing over two straight quarters of poor market returns.

More accounting blowups, lousy earnings and fresh doubts about the economic recovery could put the market on another dizzying down-leg. WATCH OUT FOR NEXT CURVE BALLS

People are spending a lot of time wondering what else could go wrong.

The Street got a left hook from Enron, and a right hook from Tyco and then took a body blow from WorldCom.

Normally, the trick for investors is to align the level of stock prices with earnings potential. But this is proving to be a major accomplishment in these days of misrepresented balance sheets. In fact, it's nearly impossible to figure out the value of stocks when people can't trust the numbers coming out of a lot of companies.

The average stock is also far and away above what can be supported by the market. The best bet is that people should get ready for tremendous market churning and volatility until late this year or early in 2003 when investors should have a clear picture of the shape of the market and economy.

Some investors have already kicked the habit of buying U.S. stocks. Offshore investors have lost faith in American accounting practices and they don't see the crisis of confidence caused by the scandals as just Enron and WorldCom specific. As they say on the Street, "When you see one cockroach, there's bound to be a whole bunch more waiting to come out of the woodwork."

By some estimates, foreign investors have been pouring $1 billion a day into U.S. markets. But the latest numbers show a trend toward repatriation of money by Asians and Europeans to the home front where financial markets are more predictable.

The offshore people are pricing in a new scenario. Even in economically troubled Japan, the Nikkei stock index is up this year and the Japanese yen soared this week to an eight-month high against the dollar.

One clear sign of the migration of money: corporate and portfolio investment in stocks and bonds to the euro zone soared in April to $19 billion, the sharpest increase in the past year, according to the European Central Bank.

The strength of the euro, the single European currency, suggests that foreigners are dumping dollar-denominated investments and loading up on euro-based assets.

A story that may play out in the second half could be the euro reaching parity or surpassing the dollar, which would add to Wall Street's pain. The long struggling euro is only an easy one-foot putt away from making par.

The other serious argument against investing in United States markets is the declining dollar and Washington's insistence in allowing speculators to determine the "right" level for the currency.

The speed of the dollar's erosion this year has unsettled foreigners who must not only dodge the Street's bullets but also worry about being paid back with cheaper dollars when they exit the market.

One possibility is that a lot more foreigners may pull their money out and shift to European and Asian stock markets. Negative money flows from overseas could be the next thing that will afflict American stocks. SMART MONEY GOES GLOBAL

"The global sector approach to investing may represent the most powerful change in global equity investing since the surge in emerging markets a decade ago," says Jay Pelosky, global strategist for Morgan Stanley. "It could lead the equity world for the next few years, particularly if the U.S. markets underperform."

Global fund managers are rapidly changing the way they invest, he says. They are moving away from a U.S.-centric focus and looking at the global picture.

"Two years ago, investors demanded the purest vehicle with the highest returns as greed outweighed fear," says Pelosky. "This led from investing in equities to investing in tech-segment funds and vehicles. The result was a rigid investment structure that ensured poor returns when the bottom dropped out."

For the 3 1/2-day holiday-shortened trading week, the S&P 500 was down about 0.1 percent to end at 989.0, the Nasdaq down 1.1 percent at 1,448.36 while the Dow index rose 1.5 percent to 9,379.50.