One bear turns US rally into a rout

News Analysis: Wall Street plunged 299 points last week. Was this a case of August shakes?

"ANY BIT of noise gets amplified during the summer," said PaineWebber strategist Edward Kerschner, last week, "because the market is very thin." Many people are away on holiday, or their minds are in the Hamptons while their bodies still lull in midtown Manhattan.

Mr Kerschner himself delivered his wisdom from a boat on the Danube.

So was that all there was to last week's 299 point plunge in the Dow? A simple case of the August shakes? As Wall Street regrouped, there was little consensus amongst the stock analysts or the economists about where the stock market goes from here.

There is some reason to think that the recovery may continue this week, and the US economy remains fundamentally sound, with little indication of either monetary policy shifts or a sudden plunge in growth. Yet all around there are worrying signs, notably in Asia.

By the end of the week, the Dow Jones Industrial Average had recovered over a third of Tuesday's precipitate decline. The S&P 500 slipped a little, but advancing stocks led decliners on Friday, as the market started to recover a little confidence.

The bulls amongst the analysts had peeked out into the storm, and pronounced themselves still confident that the rally would continue. Led by Goldman Sachs' Abby Joseph Cohen, they said that the correction was overdone. Strategists for PaineWebber, Donaldson Lufkin & Jenrette, Salomon Smith Barney, and others said Wall Street would recover to end the year higher.

It was the comments of another analyst, Ralph Acampora of Prudential, which helped to turn Tuesday into a rout. The 31/2-year rally was "very tired," he said.

There is some evidence behind that comment. The broader market, for instance, has looked weak for months, and to some extent what happened this week was that the larger capitalisation stocks caught up. Mr Acampora pointed to declines in corporate performance as the Asian downturn hit US exports.

So far, the US economy has been highly resilient in spite of the Asian crash. There has been no indication as yet that it is in serious trouble; though recent statistics have shown a slowing of growth, that is hardly surprising given the 5.4 per cent annualised growth in GDP in the first quarter.

The domestic economy remains relatively strong as the Federal Reserve's Beige book showed last week. It analyses growth in the different regions of the US economy. Though the survey was generally positive, it did note that there were problems showing through.

"Many districts noted that labour shortages, shipping bottlenecks and continued weakness from East Asia were beginning to temper growth in their regions," it said.

Alan Greenspan, the Fed Chairman, warned two years ago that "irrational exuberance" had taken hold of the market, but since then, his warnings have been much less outspoken. Instead, his appearances before Congress have been characterised by a mixture of admiration and sheer puzzlement at the continuing performance of the economy.

The Fed next meets on 18 August, and as yet there is little to indicate that it will either raise or cut interest rates.

The investing public seem to have taken a relatively relaxed view of last week's slump, with little indication that they had turned sour on stocks. Fidelity Investments reported few movements from equities to cash and bonds; other funds even saw investors moving into equities at what they saw as good prices.

It was programme trades and nervous institutional investors who were moving the market. That could be good or bad news. The bull market has been powered by the rush of cash into mutual funds, which has had a healthy relationship to strong domestic economic growth.

While individuals have seen their investments racing ahead, increasing their spending power, they have helped to stoke the fires of a domestic boom. If suddenly caught out, that relationship could reverse.

The coming week has a clutch of important economic data releases, including second-quarter productivity figures, and retail sales and producer prices for July. These will help to show whether the consumer boom continues, and whether the slowdown in growth has shown up underlying weaknesses in the key US unit labour costs.

So far the markets seem to have shown scant interest in the real economy. There will also be second-quarter results from some important corporations, including a slew of the biggest retailers: Wal-Mart, K-Mart, and Gap. The available evidence suggests that despite the slowdown, the retailers have had a strong year so far, which might cheer the market.

But there are three long-term issues hanging over the market that will not go away. The first is Asia. So far, the impact on America has been relatively slight, but a devaluation of the Chinese currency, and a concomitant fall in the Hong Kong dollar, would hit confidence very badly.

The second factor is whether further instability starts to panic individual investors. They have more of their assets tied up in stocks than at any time in the last 50 years, and daily images of panic do not get breakfast off to a good start. So far, investors seem to have concluded that it was seasonal volatility, not fundamental weakness, which hit the market, and their happy experiences of the last three years have conditioned many to believe that what goes down must go up.

The public display great confidence in the economy in opinion polls - greater than at most periods for the last three decades. But at some point that will change.

The third factor is uncertainty. The market has been highly unstable over the last week, partly because there is genuinely no consensus. Many cannot see what is keeping the market up - beyond skyhooks.

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