New Rule of Stocks: Get Used to Grind

The stock market is acting like a tease.

It rises to a record, or near one, and then falls back. Just as investors start to fear a big decline, stocks recover. They get back near a record and, whoops, they fall again, and the yo-yo action resumes.

This marks a big change from last year, when the main indexes rose 25% to 30%, their best in more than a decade. This year, the S&P 500 is up 1% and the Dow Jones Industrial Average is down 1%.

Money managers and analysts have several explanations centering on the scale of previous gains, the scope of central-bank support for markets and the outlook for corporate profits. Meanwhile, they are beginning to caution clients: This choppy market is more normal than the buoyant one we have seen since 2009, and the erratic action could become more common now.

"It is a slow, grinding process. It is going to take some getting-used-to," said Mark Freeman, chief investment officer at Westwood Holdings Group Inc.(WHG), which oversees $19 billion in Dallas. It is possible that "this is what we will be doing over the next several quarters," he added.

Why has this happened? Several reasons: After doubling or tripling since 2009, stocks aren't cheap any more. Companies, meanwhile, are finding it harder to keep raising earnings in a period of soft economic growth. This makes investors more cautious. But because speculative excess still hasn't reached the extremes of past bubbles, and because the Federal Reserve is determined to sustain the recovery, there is less fear of a big decline.

One thing behind the changed market, Mr. Freeman said, is that the Fed has started slowly rolling back its exceptional support. It is gradually ending the unprecedented bond-buying program that dumped more than $1 trillion into financial markets. Some time next year, economists expect it to start raising its target rate for overnight lending, its main means of tightening monetary policy.

"We view this as a transition period" away from a market fueled by easy money and toward one driven by traditional forces such as economic growth and company profits, Mr. Freeman said.

"In periods of transition you get what we are seeing now. You see a modest uptick in volatility and there is a lack of direction," he said.

Investors are trying to figure out how well corporate earnings will grow with less Fed aid. Analysts project just 3.3% first-quarter earnings gains for companies in the S&P 500, the smallest since mid-2012, according to Thomson Reuters I/B/E/S. Analysts are hoping for better later this year, but no one knows.

A big complication is that many companies are reaching the limit of their ability to boost profits by cutting costs, said Jerry Webman, chief economist at OppenheimerFunds, which oversees $237 billion in New York. More companies now need to focus on building revenues, which means higher costs for investment, hiring and wages.

"More paychecks and fatter paychecks will dampen earnings in the short run but improve spending and help in the longer run," Mr. Webman said. "As there is more hiring and investing, we probably see more rapid growth in the second half of the year."

Analysts project that the S&P 500 companies' revenues rose just 2.7% in the first quarter, according to Thomson Reuters, even less than their expected earnings rise.

The days are ending when Wall Street will reward companies for holding down wages and doing little investing, Mr. Webman said.

"There is going to be a need for companies to figure out how they can sustain earnings, having squeezed pretty much what they can squeeze from the existing labor force," Mr. Webman said. "The rest of the year will be better than the first quarter but there will be a greater dispersion of winners and losers."

Given all the uncertainty, why haven't stocks fallen harder?

One reason is that investors still haven't hit the extremes of irrational exuberance they reached before previous bear markets, said Phil Roth, a director of the Market Technicians Association, a professional association for technical analysts.

For years, he said, the market has been driven by hedge funds and other short-term traders, and by corporate stock buybacks. Individuals, pension funds, money managers and financial institutions have been bit players, he said, based on mutual-fund data and the Fed's investment tracking.

"The hedge funds have been trading with one another and that is all that is going on. Some of them have backed off and that gives you this mixed picture," Mr. Roth said. "For every guy who says it is going down 10% there is another guy who says, 'I am going to buy it on that dip because I don't think it is going down that much.' "

The result is a choppy, up-and-down market.

Mr. Roth, who saw the trouble coming in 2007, doesn't see the same frothier market today.

Margin debt, a measure of the use of borrowed money to invest, is at a record high in dollar terms. But as a percentage of market value, it is 2.6%, still between the 2008 low of 2.3% and the 2007 high of 2.8%, Mr. Roth calculates.

Trading volume on the Nasdaq stock market, with its many young, hot companies, can be another indicator of excess. When speculative fever is high Nasdaq volume can equal that of the New York Stock Exchange. Last week it was 68%, Mr. Roth said.

Initial public offerings of stock, which often explode at market highs, also aren't at past extremes.

So speculation is up, stocks are pricey and markets started looking frothy last year, but "the market hasn't shown enough excess to warrant a big correction," Mr. Roth said.

A serious economic reversal could change that and push stocks down, but there aren't any signs of that yet, he added. Instead, "people have been selling at the top and buying when stocks are down," which, he said, is fairly standard market behavior.