Sunday, September 18, 2005

It's Fourth and Long for Stocks

September 18, 2005

The stock market is heading into the final stretch of 2005 in what could be the first down year for U.S. stocks since 2002. While there's plenty of cause for concern in the fourth quarter, there's starting to be some reason for hope, too.

First the bad news. Economists are still scrambling to assess the economic damage wrought by Katrina. Bank of America says that the hurricane destroyed national wealth of at least $50 billion, and perhaps as much as $100 billion. Crude-oil prices have been hovering in the mid-60s, stoking inflation fears and worries that consumers are going to spend less if they're paying more at the pump.

Yet the fourth quarter historically has been the best one for stocks, and some investors are counting on history repeating. They say that the economic impact of Katrina could be painful but most likely is temporary. After topping $70 a barrel, oil prices have retreated to $63, and the economy still looks to be in decent shape.

Indeed, most analysts now think the Federal Reserve will feel comfortable enough with economic growth prospects to raise interest rates again when the policy committee meets Tuesday. Moreover, with European and Asian markets chalking up good gains this year, some market pros suggest U.S. stocks are poised to play catch-up over the next three months.

"If you look at the stock market without emotion, you have to wonder why it isn't moving higher like the other major markets in the world," says Jim Paulsen, chief investment strategist for Wells Capital Management. For the year, the Dow Jones Industrial Average is down 1.3%, compared with gains of 12% or more in Tokyo, London and Germany.

Not everyone shares this optimism. Russ Koesterich, senior fund manager at Barclays Global Investors, sees a few dark clouds. For one, the sharp rise in oil prices has come as the U.S. savings rate is close to zero. During previous oil-price surges in the 1970s, he notes, the savings rate was between 7% and 10%. That means consumers have less of a cushion if oil prices start moving up again.

Reading the Signals

Mr. Koesterich also dismisses recent consumer-confidence numbers that showed continued strength -- though the latest confidence numbers, released Friday, were notably weaker in reaction to the aftermath of Katrina. He argues that there's not a strong correlation between those numbers and actual spending habits. Instead, he focuses on same-store sales numbers. "Those are telling us that spending is decelerating," he says.

Just last month, retail giant Wal-Mart shook up the market when it posted its smallest profit gain in about four years and lowered its profit forecast for the remainder of the year, saying customers were spending less because of high gasoline prices.

Even the bond market has been signaling that the economy is due for a slowdown. The Treasury yield curve, which plots the relationship between Treasury debt of different maturities, has been flattening out in recent weeks.

That means the difference has been narrowing between the yield offered by short-term Treasury debt and the yield on the 10-year note. If the two-year note's yield rises above that of the 10-year note, then the yield curve will be said to be inverted -- a phenomenon many economists say signals the economy is decelerating.

Still, Mr. Koesterich thinks the Fed could bail out the stock market. Even if, as expected, the Fed raises rates a quarter percentage point to 3.75% this week, any sign that it may be nearing the end of this tightening cycle would be well received by stocks, he says. "Then we could squeeze out some gains," Mr. Koesterich suggests, "but I'm not expecting fireworks."

The case for bigger gains, others say, is stronger if investors take a closer look at the economy: Economic growth for 2005 should come in between 3% and 4%, long-term interest rates remain low, inflation appears to be largely under control, job creation is rising and the housing market -- despite numerous warnings of a bubble about to burst -- remains firm.

Healthy Profits

Moreover, analysts have been underestimating profit growth for most of the past two years, turning more conservative after being too bullish in the late 1990s. Mr. Paulsen points out that overall corporate profits rose nearly 18% in the second quarter compared with the year-ago period. "That was far better than people expected even 90 days ago," he says.

Lehman Brothers in a report this month also recommends an overweight position in stocks, citing the strong balance sheets at most companies and the relatively attractive valuations of stocks compared with bonds.

At the same time, some analysts argue that the recent headline concerns may be overstated. Ajay Kapur, director of global-strategy research for Citigroup, argues the inflation threat in particular has been overblown. He says high oil prices won't necessarily slow down the economy significantly unless they lead to broader inflation. "No signs yet," he wrote in a report earlier this month.

And as order slowly returns to New Orleans, some economists suggest that the disruption from Katrina may be more contained than once thought.

"Typically, in the immediate aftermath of natural disasters such as hurricanes, the economic impacts -- both their magnitudes and durations -- tend to be overstated," Bank of America chief economist Mickey Levy wrote in a recent report. He is now forecasting a moderate deceleration in economic growth and declines in profits, but "these impacts are likely to remain temporary."

Joseph Battipaglia, chief investment officer for Ryan Beck & Co., agrees, noting in a September report that Louisiana and Alabama account for around 2% of total U.S. economic output. More worrying to the economy, 90% of the Gulf Coast's oil production has been shut. But, he adds, "timely restoration of both output and processing has been established by authorities as a high-priority item."

So what stocks might lead a fourth-quarter rally? Mr. Paulsen thinks energy stocks have had their run this year and instead favors technology shares.

Mr. Koesterich likes companies in sectors such as health care that can raise prices even when inflation is low. Worried that the consumer may be flagging, he would avoid auto makers, mainstream retailers and department stores. Instead, he likes companies in sectors that cater to business spending to take advantage of strong balance sheets, including industrials and technology.


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