Bargain-basement prices, empty wallets. You do the math.

Fund skippers around the world are growing increasingly optimistic about the overall climate for equity markets and believe that stocks are still undervalued, according to a recent poll conducted by Merrill Lynch of New York. But despite the rash of potentially lucrative buying opportunities, portfolio managers are finding it difficult to take advantage of attractive stock valuations, as cash levels remain historically low.

Indeed, the average cash balance of the survey's participants fell to 4.2% in January, marking the third straight month of declines. That compares to 4.4% in December and 4.6% in November. Cash positions among funds typically have closer to 6%, the survey indicated. Meanwhile, the number of managers who think stocks are cheap rose to 27%, up from 21% in the previous month, a significant data point considering the decent run-up stocks enjoyed during during the period - roughly a 2% to 3% spike. And more than two-thirds of the 307 respondents now believe that equity returns are likely to exceed bond returns in 2003

"Either this is a very cheap market, where high levels of risk aversion are preventing the proper allocation of capital to equities. Or fund managers are already fully invested in the belief that it is cheap," said David Bowers, chief global investment strategist at Merrill, in the report.

In the event that stocks are undervalued, managers may have to pare their non-equity holdings in order to generate enough liquidity to capitalize on such attractive valuations. The latter scenario would be a much more negative indication for the market, but Bowers said that it is too soon to determine which is the case.

"Time will tell, but one thing is certain: there does not appear to be much cash waiting in the wings," he noted. Historically, the survey has suggested that the most profitable times for equities have been when the market is both cheap and where fund managers have a surplus of cash to put to work. "That's not the case today." Bowers argued.

Fund Redemptions Ahead?

"Many mutual fund managers are fully invested," said Keith Keenan, vice president of institutional trading and a partner at Wall Street Access. "They have limited cash and fund flows have been weak. [That], coupled with geopolitical tensions, is why volume remains very weak. In fact, I think a much weaker-than-expected Q2 earnings [season], and Q3 outlook will trigger fund redemptions," he said.

Over the course of the last six months, asset allocation in the mutual fund industry has undergone a major overhaul, the survey revealed. Fund managers have been adding more technology and telecom names to their portfolios, two areas that had been widespread underweights previously. Meanwhile, they have also scaled back their positions in cyclical groups such as media, retail and automotive. That suggests that managers have become less concerned with the cleaning up of corporate balance sheets and are starting to become warier of sectors exposed to the consumer balance sheet. Perhaps consumer spending, which has served as a crutch for an otherwise legless economy, has begun to splinter.

Scorned By Sharks

Individual investors, while slowly gaining confidence in improving economic conditions, are still largely reluctant to pony up the dough for shares. And rightly so, as they have watched their investments go up in smoke while corrupt analysts and top-level executives were living high off the hog. Enron, WorldCom, Adelphia, Tyco, ImClone, the list goes on. When that trust was breached by some of Wall Street's biggest and most fraudulent sharks, scorned investors were left wondering when it was safe to go back in the water. While much of the corporate scandal chatter has petered out in recent months, some of the collateral damage and psychological fallout still remain. A case of "once bitten, twice shy" is what some market analysts are calling it. On top of that, one has to factor in the heightened sense of fear sweeping the nation as the U.S. military mobilizes for a war against Iraq and the possibility of further terrorist activity on American soil mounts.

Merrill contends that despite a long road ahead in repairing companies' balance sheets, the U.S. equity market is on par with global emerging markets as having the best corporate profit outlook. But the fact remains that there is a total lack of conviction in the market right now and that uncertainty makes it difficult to project growth. "The intensification of geopolitical risks makes discerning the economic path ahead especially difficult," said Federal Reserve Chairman Alan Greenspan, in his monetary policy report to Congress last Tuesday.

So with fund managers handcuffed by limited liquidity, asset allocation in a state of flux and the U.S. on the brink of war, a rally in the U.S. stock market is unlikely. To wit, the Dow Jones Industrial Average is at its lowest levels since late October, and things may get worse before they get better.

"Ultimately, I think the October lows are going to be taken out," Keenan said. "I think the Dow will test 6000-6500 level, and the Nasdaq will test 1000 before the bear market ends."

Copyright 2003 Thomson Media Inc. All Rights Reserved.

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