News Analysis
BusinessWeek.com
June 1, 2006
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A Miserable May for Markets

Interest-rate uncertainty and a flight from risky assets have investors saying "Mayday." And the roller-coaster ride may not be over

Investors heeding the old dictum "sell in May, then go away" might be wishing they had hightailed it a little earlier this year (see BW Online, 4/26/06, "A Savvy Seasonal Stock Strategy"). For the month, the Dow Jones industrial average fell 1.8%, the broader Standard & Poor's 500-stock index dropped 3.1%, and the tech-heavy Nasdaq composite index slid 6.2%.

What's behind the markets' malaise? Uncertainty about the Federal Reserve's course on interest rates, increased risk aversion, and debates about inflation and slower economic growth contributed to the downturn, market pros say. The bad news is, stocks' recent topsy-turvey ride may not be over yet.

It may seem like ancient history, but the markets actually started the month poised for record gains. On May 10, the Dow hit a six-year closing high of 11,642.65, just 80.33 points from its all-time peak. Companies in the Standard & Poor's index were enjoying their 16th consecutive quarter of double-digit percentage earnings growth, while surging commodities prices drove metal companies such as Alcoa (AA ) and Phelps Dodge (PD ) to 52-week highs. Since then, the Dow has dropped 4.7%, and other indexes have been hit even harder.

RUNNING FROM RISK.  The turning point came with the Fed's last interest-rate hike, analysts say. On May 10, the Fed raised the key federal funds rate to 5%, as expected, but it also left the door open for further tightening (see BW Online, 5/11/06, "Interest Rates: Look, Ma, No Pause!"). "The markets anticipated seeing the red light at 5%," says Art Hogan, chief market analyst at Jefferies & Co. "Everything has been perceived as a negative for the markets after we didn't get that clear message."

At the same time, investors have been fleeing riskier asset classes that had roared ahead, such as emerging markets, commodities, and small-cap stocks. The S&P/IFCI Composite index, which tracks emerging markets, tumbled 9.4% for the month through May 30. The Reuters-Jefferies CRB Futures Price Index fell 2.1% over the same period, despite climbing 2.9% through May 11. The Russell 2000 index, a benchmark for U.S. small companies, was down 7.1%.

In the midst of this shift, the market is left searching for leadership, others say. As energy, metals, and mining names lose luster, large-cap names and companies with strong balance sheets could come out in front, according to Tobias Levkovich, chief U.S. equity strategist at Citigroup. "We think that large-cap and large cash wins," he wrote in a May 30 dispatch, noting that small and mid-cap stocks have led the way for nearly 80 months. Indeed, many market watchers have been predicting that large-caps would stage a comeback this year (See BW, 12/26/05, "The Bulls: Pawing and Snorting").

TOO CLOSE FOR COMFORT?  Since the last Fed meeting, reports showing stronger than expected inflation have spooked investors. On May 17, the Labor Dept. reported that the core consumer price index, which excludes energy and food prices, rose 0.3%, slightly ahead of expectations (see BW Online, 5/17/06, "Stocks Tumble on Inflation Worries").

The report raised the odds the Fed will have to hike rates again in June, Lehman Brothers economist Drew Matus said at the time. On May 26, the Commerce Dept. said the core personal consumption index (PCE) deflator, also excluding energy and food, rose 2.1% in April from a year earlier. It was biggest year-over-year increase in 13 months for the Fed's preferred inflation gauge. Chicago Fed President Michael Moskow said on May 30 that the data indicate an inflation level at the "upper end" of his comfort zone.

A weakening dollar has also loomed. Nevertheless, some analysts say dollar pessimism has been overblown (see BW Online, 6/1/06, "Dodging the Dollar's Decline"). "We think dire warnings of an imminent collapse of the greenback are off base," notes Jay Bryson, global economist at Wachovia. Nor is dollar policy likely to change after the appointment of Goldman Sachs Chairman and CEO Henry Paulson to succeed Treasury Secretary John Snow, according to Bryson (see BW Online, 5/30/06, "Paulson to the Rescue?").

POINT BY POINT.  On the bright side, the housing market hasn't crashed, as some experts feared. Instead, the data have pointed to a gradual slowdown. The National Association of Realtors recently said domestic existing home sales slipped 2%, to a 6.8 million pace in April, from 6.9 million in March. On May 18, former Fed Chief Alan Greenspan said "the boom is over" for housing, in his first public U.S. speech since retiring.

Considering the conflicting signals, the Fed remains uncertain about whether to pursue a 17th consecutive rate increase, judging from the minutes from its May 10 meeting. Options on the table ranged from a 50 basis-point increase to a pause, the minutes show. After the May 31 release of the Fed minutes, futures markets indicated a 74% chance that policymakers will raise rates to 5.25% when the Fed meets June 28-29. That's up from 58% odds a day earlier.

An employment report June 2 could give investors an idea of what to expect. May nonfarm payrolls are projected to rise a modest 163,000, says economic researcher Action Economics. However, nearly a full month of economic data lies ahead for investors before the Fed's meeting. "Every data point has much more meaning again," says Joseph Battipaglia, executive vice-president and chief investment officer for Ryan, Beck & Co.

NEWBIE BLUES.  Some of the stock market's recent downtrend may just be typical for a mid-term election year, says Jeff Kleintop, chief investment strategist for PNC Advisors. "The market usually runs up in the first quarter, peaks in the second quarter, then tends to fall," Kleintop says. "We're following that classic pattern." He adds that government projections of another busy hurricane season could also hang over the market through the summer. Then, he predicts "a classic fourth-quarter rally."

For the time being, investors should keep their seat belts buckled. Stocks historically have higher volatility and lower returns in the first year under a new Fed chairman, according to Mary Ann Bartels, chief U.S. market analyst at Merrill Lynch. Says Bartels in a May 30 report: "Markets are likely to remain volatile until the Fed gives the markets more clarity."