Wall St. Looks Hard for Sense of Direction

You can almost smell the mix of hope and desperation on Wall Street as December nears.

Among market pros, belief is widespread that a year-end stock rally is inevitable -- and enough of a rally to significantly improve on the low-single-digit gains that broad market indexes now are showing for 2005.

There also is widespread fear of the potential fallout if the recent rebound in stocks fizzles.

For one thing, a lot of professional money managers may find themselves bonus-free early next year if their portfolio performance doesn’t improve markedly in the next six weeks.

What’s more, there is a risk that lousy numbers staring at investors from their year-end brokerage and mutual fund statements could further sour them on U.S. stocks, setting a bad tone for 2006.

As a place where investors want to stash their dollars, the American equity market already has been relegated to second, third or even lesser fiddle this year. Real estate, of course, has been No. 1 on many peoples’ must-have list. Cash in the bank also has gotten more interesting as the Federal Reserve has continued to push up short-term interest rates, now at four-year highs.

And even when they’ve directed money toward stocks, far more investors this year have opted to buy foreign shares than U.S. shares, at least as measured by cash inflows to mutual funds.

That has been a smart call: The average foreign stock fund is up 11.1% year to date, compared with a 5.9% gain for the average U.S. fund, according to Morningstar Inc.

For the U.S. market overall, this year is looking like a downsized version of 2004: Once again, the blue-chip Dow Jones industrial average is struggling to eke out a gain. Even after four straight up weeks, the Dow was down 0.2% for the year as of Friday, not including dividends.

But as in 2004, profit opportunities in equities haven’t been as tough to come by as the Dow’s struggle might suggest.

A Standard & Poor’s index of 600 small-company stocks is up 6.8% for the year. An S&P; index of 400 mid-sized stocks sports an even better gain, up 9.9%, to a record high as of Friday.

And check out the Dow transportation stock index. Google it isn’t, but the transport index is up a respectable 9% for the year, thanks to a run-up of more than 15% since mid-October, as falling oil prices have helped to stoke fresh interest in railroad, trucking and airline shares -- or at least in the airlines that aren’t in Bankruptcy Court.

Still, investors are more likely to own an S&P; 500 index fund than a transportation stock fund. And the blue-chip S&P; 500, like the Dow, doesn’t have a lot to show for itself this year. It’s up 3%, or 4.7% with dividends.

What has kept the broad market subdued is a sense that there’s much more that could go wrong than could go right in the economy and in markets.

Venice, Fla.-based Ned Davis Research, a data firm well known on Wall Street, turned negative on the U.S. market early in October. The firm advised clients to cut their U.S. investment portfolio to 40% stocks, from 55%, and keep the rest in bonds and cash accounts.

Tim Hayes, chief investment strategist at Ned Davis, said the firm hadn’t been this downbeat on U.S. shares since 2000, when the last bear market began.

With the Federal Reserve continuing to tighten credit and energy prices still elevated, although off their recent peaks, “We think the market risk is pretty high now,” Hayes said.

It doesn’t help, he says, that expectations for at least a temporary market rebound are so widespread among market professionals.

“So many people have been talking about this year-end rally idea,” he said. That just boosts the potential for disappointment, in his view, because the market typically loves to disappoint the majority.

On the other hand, it’s true that year-end rallies have been the norm rather than the exception, historically. Since 1989, the S&P; 500 has risen in the fourth quarter in 14 of 16 years. (Declines occurred in 1994 and in 2000.)

Bruce Zaro, chief market technician at Delta Global Advisors in Huntington Beach, says that if the market wanted to shock most people, it would rise -- not fall -- through year-end and into early 2006.

“Because there seems to be so much to worry about -- rising interest rates, avian flu, high energy prices, a politically damaged White House, the end of the Greenspan era and more -- the surprising move in early 2006 would be stock market strength,” Zaro says.

Fundamentally, the bullish case for U.S. stocks doesn’t seem like such a big stretch. The economy still appears to be growing at a healthy pace, and corporate profits rose at a double-digit rate in the third quarter, for the ninth straight quarter, according to data tracker Thomson Financial. And the Fed probably is closer to the end of its interest-rate-raising campaign than to the beginning.

But is any or all of that enough to get people wildly excited about stocks overall again, and soon?

Many market pros advise forgetting about the idea of a sustained, rising-tide-lifts-all-boats kind of rally. That’s usually a good bet early in a bull market, but not later in one.

Better to just make sure your portfolio has enough of what has been working well, and could continue to work well, even if the Dow and S&P; 500 remain uninspired.

Hayes, for example, says the Japanese market looks like it is in a long-term recovery after a 13-year bear phase ended in 2003. Despite the strong dollar, which has hurt U.S. investors’ returns in Japanese shares, the average Japanese stock fund available to U.S. investors is up 19% this year, according to Morningstar.

John Bollinger, head of Bollinger Capital Management in Manhattan Beach, says he is sticking with small- and mid-sized U.S. stocks, which have on average beaten blue chips every year since 2000.

“The economy has been doing much better than people expected,” Bollinger said. In that environment, small- and mid-sized companies offer the best opportunities for strong earnings growth, he said. Compared with corporate giants, smaller firms “still have room to penetrate their markets” and boost sales and profit, he said.

John Buckingham, president of Al Frank Asset Management in Laguna Beach, believes shares of energy companies and home builders remain in long-term bull markets, and that recent declines are a great opportunity to buy. In the energy sector, for example, he likes Chevron Corp., which is up 11% year to date but is down from nearly $66 at the end of September to about $58.

Anyone contemplating a year-end shift in their investment portfolio, however, should first think about how long they’d be willing to keep their new holdings. There’s investing, and there’s pure speculation.

Or, as Buckingham puts it: In your stock or fund picking, are you just looking for a hot date for the next few weeks -- or do you want something you can be married to in 2006 and beyond?

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Tom Petruno can be reached at [email protected].

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Mid-cap winners in a dull market

Shares of mid-sized, or mid-capitalization, companies have been

particularly strong this year compared with blue chips. Here’s a

look at some of the mid-cap names that have been hot in 2005.

*--* P/E on Fri. YTD ’06 est. Company Business close change EPS(1) Chico’s FAS Retail $45.02 +98% 34 GameStop Retail 36.27 +62 21 Whole Foods Market Groceries 144.59 +52 50 VCA Antech Pet clinics 27.74 +42 26 Cypress Semiconductor Computer chips 16.00 +36 38 Imation Data storage 42.87 +35 21 ITT Educational Svcs. Higher ed. 62.10 +31 23 Scotts Miracle-Gro Garden products 46.28 +26 18

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(1)P/E is the stock’s price-to-earnings ratio based on analysts’

consensus earnings per share estimate for 2006. The S&P; mid-cap index’s estimated 2006 P/E is about 16.

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Sources: Bloomberg News, Thomson Financial