Commentary > The Dobbs Report

Waiting for war
Two top strategists see a holding pattern until the Iraq crisis ends.
February 14, 2003: 11:48 AM EST
By Lou Dobbs, Lou Dobbs Moneyline

NEW YORK (Money Magazine) - The Santa Claus rally never materialized on Wall Street. And after a strong start, the January effect ended up having a negative effect on stocks.

With so many unknowns pressuring the market -- from the tensions with Iraq to sluggish corporate earnings -- investors are showing continued caution.

This month, I asked two top strategists on Wall Street for their outlook. I also asked them which economic and geo-political forces individual investors should be paying the most attention to in the months ahead.

Liz Ann Sonders, the chief investment strategist at Charles Schwab, says she has "a bias on the upside for this year." But she thinks that to a great degree market direction will hinge on what happens with Iraq.

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"I think it's the economy that is going to drive stocks and investors," she says, "but I think we're not going to get a clear sense of the economic strength until we have some of the uncertainty related to Iraq cleared. It's impacting business confidence, certainly individual investor confidence, and therefore has tentacles into just about everything."

However, she adds, "one of the nice things about this holding pattern is that the fundamentals underneath are starting to look a little bit better. So, you're building some momentum to the point where if we see some of these uncertainties lifted, we'll be in a much better position in terms of the economy and the market."

Carlos Asilis, U.S. equity strategist at J.P. Morgan, is less optimistic. [Asilis resigned from J.P. Morgan on Feb. 3 to work for the New York-based hedge fund Vega Asset Management.]

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He thinks the Standard & Poor's 500-stock index will finish the year at 800 (it recently traded around 830). Asilis has several reasons for his gloomy view. First, price/earnings ratios are high, he believes: "We still find equities to be expensive at these levels, given the current level of earnings and prospects for earnings growth over the next few years."

He also thinks corporate earnings will be weaker than many other analysts expect, in part because companies are having a hard time raising prices for their products. In addition, he says, some factors that helped companies keep costs down last year -- such as high productivity growth -- may not recur to the same degree this year.

Weakness in overseas economies is another concern. "International markets account for close to a quarter of S&P revenues," he says. "So what happens overseas is important."

As is what happens in Iraq. "We do think that ultimately the economy is going to be recovering this year after all of the dust settles and Iraq is no longer an issue," Asilis says. "But we think that the pace of the recovery, in earnings particularly, is going to be somewhat subdued."

Iraq hurting guidance

Like Asilis, Sonders sees reason for caution on earnings. She notes profits for the fourth quarter of 2002 are coming in slightly better than expected.

At the same time, though, "there's a lot of cautious commentary by CEOs" accompanying those earnings reports. She cites two possible explanations for that caution.

"No. 1, all this uncertainty. It would be odd for CEOs to step up to the plate and be overly optimistic about the future, given all the uncertainties we face. But I also think we may be experiencing the opposite of what we did a couple of years ago -- analysts and companies are in a position now to be less optimistic about the future, while at the same time reporting better than expected numbers. That's opposed to a couple of years ago when they were still talking very optimistically about the future while they were underperforming expectations."

While earnings remain important, both Sonders and Asilis agree developments in Iraq are key to the stock market's progress. "The onset of military action would be a big market-moving event," says Sonders. "And my gut tells me that market reaction might be more positive than negative -- similar to what we saw in the early 1990s when we finally attacked in Kuwait -- because at least the uncertainty related to timing disappears."

She adds if there were some positive development that precluded military action -- if Saddam went into exile, for example, or were ousted in a coup -- it would be very positive for the markets. On the other hand, Sonders says, another terrorist attack on U.S. soil is not priced into the market right now. "So we've got both upside risk and downside risk," she says. "Hence this holding pattern."

Asilis agrees Iraq dominates the short-term outlook for the market. "My sense is that, ultimately, any significant upside for the markets over the near term has got to be a result of these Iraq issues," says Asilis.

"My sense is that if war or hostilities break out, odds are very good that the West will win out within a very short period of time. If that were to happen, it would provide a significant boost to business confidence and, to a lesser extent, consumer confidence." He adds the waning of Iraq as an issue could improve the market outlook sometime in the second quarter.

Tracking the economy

As for key economic factors to watch, Asilis says pricing power is of major importance, although this can be difficult for individual investors to monitor. One crucial indicator that is easy to keep an eye on: the price of oil. "If oil prices drop significantly," he says, "that would be a tremendous boost to both the economic outlook and the earnings outlook."

Sonders agrees about the importance of oil prices, saying they're playing a key role not only in investors' perceptions but also in consumers' attitudes. "Corporate America is also paying close attention," she adds, "because oil prices have an impact on earnings."

Sonders says a protracted period of well above average oil prices is certainly going to "crimp not only earnings for corporations but the amount of disposable income individuals have."

Employment figures are among the readings Sonders tracks, but she cautions investors that unemployment is a lagging indicator. "Often what you see in employment is a huge snapback," she says.

"It tends to get compressed way down at the end of a downturn and then normally springs back up very quickly when the economy starts to recover. In other words, companies are very unwilling to lay workers off until it becomes their only choice. Then when the economy starts to recover, they have to quickly boost their payrolls again."

Sonders also watches the Institute for Supply Management surveys. "The two most recent ones for manufacturing and services were very, very strong," she says, adding that those reports did a lot to help push the stock market up earlier this year. But she would like to see more strong reports to be sure that the most recent ones were not simply "one-time blips."

Among the sectors Asilis likes are energy, consumer staples, health care and materials. "We like those sectors because of the strength and pricing power that we see in them," he says. Also, "balance sheets are strong for companies in those sectors," he continues, "and the visibility of earnings growth is higher for those sectors than the overall market, in our view."

Sonders doesn't see "one glaring sector" that jumps out right now. "I think that more than any other time -- at least probably in the last decade -- we're going to see performance specifically related to the fundamentals of the individual company," she says.

"There will be less of an opportunity in this market environment to play broad themes. I think that's important because it's more of a stock picker's market and the tide may not lift all the boats within one sector. Every decade we seem to have a theme of what works, but I don't know that we're necessarily going to have such a dominant theme in this decade."

Indeed, the only theme that seems to be dominant on Wall Street right now is the need for investors to remain cautious and informed.

Lou Dobbs is the anchor and managing editor of CNN's Lou Dobbs Moneyline.  Top of page

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