Waiting for stocks to rally? Don't hold your breath

Rocky start. Second-half rebound. A gain for the year. That sums up Wall Street's 2008 stock market forecast back in January.

The first part of that prediction has been dead-on. The Dow is down 15.4% this year, 20.8% below its October record high and, as of Wednesday, officially in its first bear market in almost six years.

But the comeback call is looking like a long shot.

Many stock pundits are backing off their prediction for a sizable rally in the final six months of the year. Finishing 2008 with a gain may be too much to expect.

"We will be lucky if we get back to even," says Jason Trennert, founder of Strategas Research Partners. In January, Trennert was the most bullish strategist polled by USA TODAY, predicting a full-year market gain of 14%. The Dow would have to rise more than 18% from current levels to avoid its first losing year since 2002.

What went wrong? Wall Street's upbeat outlook was upended largely by gushing oil prices. At the start of 2008 few, if any, analysts plugged $140 oil into their spreadsheets. The 50% spurt in oil this year to a record $143.57 a barrel has deepened the economic gloom in the USA and delayed an expected recovery.

Increasingly, as oil goes, so goes the stock market.

If oil shoots up to $170 a barrel this summer, as OPEC warned, or hits the $200 target of investment bank Goldman Sachs, stocks are in for a rough ride. The Dow is already near a two-year low.

"A prerequisite to having a better market is to have a major crack in oil prices," Trennert says.

But the unexpected and unprecedented rise in energy prices is not the only hammer causing major headaches for investors.

Wall Street was betting that other big negatives such as the credit crisis, housing slump and slowing economy that hampered stocks last year would be fading from view by now, paving the way for a brighter future. But it hasn't worked out that way — at least not yet.

Indeed, it can be argued that all of these headwinds are causing as much uncertainty now as they were three or even six months ago.

"Investor confidence has been jilted," says David Chalupnik, head of equities for First American Funds.

By now, the massive interest rate cuts by the Federal Reserve, which began in September and lowered short-term rates to 2% from 5.25%, were supposed to have jump-started the economy. But skyrocketing energy prices have offset much of the Fed's work.

"Recession fears have not lessened, they have increased," says Chalupnik, adding that the Fed rate cuts have fueled inflation in commodities. The sharp jump in prices on everything from gasoline to corn to meat is making it even more difficult for American families to make ends meet. Due to that squeeze, consumer confidence has dropped to levels not seen since the 1970s.

Could higher interest rates help?

Some money managers say stocks might fare better if the Fed starts raising rates. The reason: Low rates have been a big factor in the decline in the value of the U.S. dollar and the resulting price gains in commodities, which are priced in dollars.

Oil continued its rapid rise last week after the Fed opted not to raise short-term borrowing rates and hinted in its post-meeting statement that no hikes would come at its next meeting in August.

"We thought it might be a good time for a surprise move by the Fed — to have raised rates by a quarter-point to signal that they are serious about fighting inflation," noted Michael Farr of money management firm Farr Miller & Washington.

Stocks have not fully priced in the current downturn, warns Brian Belski, U.S. sector strategist at Merrill Lynch. The fact that consumers' finances are weakening, coupled with the fact that consumer spending accounts for two-thirds of economic activity, suggests that this recession will be worse than "average," Belski wrote in a recent report.

While the nation's economy, as measured by gross domestic product (GDP), has yet to suffer any quarterly declines, many Americans are experiencing a frightful financial pinch due to the cash-drain caused by higher gas prices and the ongoing decline in the value of their homes.

Credit crisis' problems linger

The credit crisis also has stuck around much longer than expected. The seeds of the financial crisis, which surfaced last summer and appeared to hit a crescendo in mid-March when investment bank Bear Stearns nearly imploded under the weight of losses tied to bad mortgages, are still sowing uncertainty.

By this time, investors had hoped that banks exposed to bad loans would have accounted for all their losses. But the full extent of the losses is still unknown. Investors are bracing for more bad news when banks release their second-quarter earnings reports in the coming weeks. Despite having already written down hundreds of billions of dollars in losses, analysts say, banks and brokerages are expected to report additional sizable losses.

"We still don't know what inning we are in (in the credit crisis)," Trennert says. "By now, you would have thought the ninth inning would be wrapping up."

The weak state of the financial sector is a key reason the broader market is struggling to gain its footing. Financials in the Standard & Poor's 500-stock index have suffered more than $1.2 trillion in losses since its Oct. 9, 2007, high, compared with a loss of just $263 billion in the 2000-02 bear market, S&P says. A year ago the financial sector represented the largest chunk of the index based on stock valuations, but it now sits third at 14.4%, behind tech and energy.

So steep have been the declines in major financial stocks (Citigroup closed Wednesday at $16.84, down 68% from its 52-week high) that comparisons with the tech-stock crash earlier this decade are being made.

"People accused me of being nuts when I went on TV the past few months to say that there is nothing in the rulebook that says a 'Citi-puke' can't go to single digits or that many names would go under," says Gary Kaltbaum, president of Kaltbaum & Associates. "Not many are battling me anymore. The same thing happened in the tech bear of 2000. No one would ever have believed a Lucent would go to $2 or WorldCom would go bust."

Kaltbaum, who is preserving capital by holding cash, is steering clear of financials deemed "cheap" by bottom fishers.

The collapse of General Motors' stock price, 77% off its 12-month high to a 54-year low, is another sign of just how badly the high price of gas has hurt consumer spending. This once bluest of blue chips is struggling to survive as drivers turn away from the gas-guzzling SUVs that it has relied on for most of its profit in recent years.

The housing market's ongoing slide is also complicating things. The continued decline in sales and prices is causing a downward spiral. As more people default on their mortgages and resort to foreclosure, it keeps the financial pressure on banks, which are already saddled with a mountain of bad debt tied to mortgages.

Banks have already tightened credit standards in response to this bad debt and their need to preserve capital to survive. That has made it more difficult for cash-strapped consumers to get access to much-needed loans.

For stocks to rally, oil prices must fall by $25 to $30 a barrel, the housing market must stabilize and the credit crisis must ease, Chalupnik says. An oil price decline of that magnitude isn't so far-fetched, despite tight supplies and the seemingly insatiable demand for energy from China and India. Richard Suttmeier of RightSideAdvisors.com predicts the crude "bubble" will burst and prices will fall to $75 a barrel once Congress cracks down on oil speculators.

The negative impacts on spending due to high energy costs are likely to add up to a massive hit to corporate profitability, the fuel that drives stock prices. Heading into the year, investors were expecting a sharp earnings rebound in the second half. But those expectations are fading.

Analysts have been ratcheting down profit estimates for the second half of 2008. Expected third-quarter profit growth for the S&P 500 is now 12.6%, down from 17.3% on April 1, says Thomson Reuters. Growth of 59.3% is still expected for the fourth quarter, but that's in comparison to a very weak fourth quarter of 2007.

"Estimates still need to be trimmed," says Tobias Levkovich, Citigroup's chief investment strategist.

Investors will be listening closely to what companies have to say about the outlook for the remainder of the year when they release second-quarter earnings reports in coming weeks. Package-delivery giant UPS last week warned of weaker business activity for the remainder of the year, citing rising oil costs. Second-quarter profit is expected to drop 11.5%, down from an expected gain of 4.7% on Jan 1.

Another risk to earnings is a slowdown in profit growth from abroad, which has been a main driver of profit the past 18 months, warns Joseph Quinlan, chief market strategist for Bank of America. He believes U.S. global earnings have peaked, citing faltering demand in Europe and a slowdown in emerging markets. "That key earnings prop is not as sturdy as it once was, and that is not yet fully recognized by investors," Quinlan warned.

James Stack, editor of InvesTech Research, calls this confluence of bad events a "perfect economic storm," which has caused the value of the stock market to decline more than $2 trillion this year.

Still, Stack points out that the Dow's current slump — which includes its worst June performance since the Great Depression — has been just nine months long, still six months shy of the median bear market (half are shorter, half are longer). But with stocks trading at 13.4 times their forward 12-month profit projections, according to Thomson Reuters, Stack doesn't yet see a severe multiyear bear market like the ones in 1973-74 or 1929-32.

Keep an eye on the S&P 500

A key thing to watch, Stack says, is if the broader S&P 500 can stay above the 1273 low it hit in March at the peak of the credit crisis. Wednesday, it closed at 1262, raising alarms. But one day does not make a trend, and if the large-stock index can climb back above that key level, that could signal that a horrible outcome is not in the cards.

After Wednesday's nearly 2% drop, the S&P 500 is 19.4% off its record high and flirting with a bear market, defined as a drop of 20% or more. The tech-packed Nasdaq composite and small-stock Russell 2000 indexes are already in bear territory.

A mega-bear at Societe Generale,analyst Albert Edwards, warns of a deep recession caused by the fallout from the unwinding of the debt bubble. The ensuing sell-off, he says, will knock the S&P 500, now trading at 1262, all the way down to 500. That equates to a drop of 60% from current levels.

But most forecasts are not as bearish. Citigroup's Levkovich says the market is on the final "V" of its "W" recovery pattern, suggesting that the current decline will eventually morph into a nice recovery.

Don't give up on the second-half rally just yet, says Phil Orlando, chief equity market strategist at Federated Investors. He expects frothy oil prices to pull back and predicts Fed rate cuts and tax rebate checks to stimulate the economy enough to jolt stocks out of their bearish phase.

"The second half will be better than the first half," he says. "The lion's share of the pain is behind us."