Wednesday, June 14, 2006

A Summer Slump for Stocks

News Analysis
June 14, 2006

Business Week Online

A Summer Slump for Stocks

Interest-rate and inflation fears are hammering stocks around the globe. Market pros advise some defensive moves to avoid getting burned

Summer doesn't officially begin until June 21, but investors are already feeling burned. Stocks have tumbled almost across the board since May 10, as worries about inflation, rising interest rates, and slowing economic growth caused a flight from riskier asset classes (see, 6/1/06, "A Miserable May for Markets"). As the meltdown continues, many market strategists recommend that investors seek protection and stay defensive.

The numbers don't look pretty. Through June 13, the Dow Jones industrial average was down 8% since May 10, when it reached a six-year closing high of 11,642.65. Over the same period, the broader Standard & Poor's 500 dropped 7.5%, and the tech-heavy Nasdaq composite lost 10.7%. All three of those indexes are in negative territory for the year. The late spring swoon has spread to major equity indexes in other countries, as central banks across the globe joined the rate-hike party (see, 6/9/06, "A Global Assault on Inflation").

It's no coincidence that the Dow's peak coincided with the Federal Reserve's most recent meeting on interest rates. Stocks' rally in April and early May owed partly to expectations the Fed would stop hiking rates after May 10, analysts say. Instead, policymakers left the door open to further increases, rattling the markets. "The Fed's suddenly inconsistent communication caused volatility to quickly rise," wrote Richard Bernstein, chief investment strategist at Merrill Lynch, in a June 13 report.

FEARFUL FED.  The nasty climate for stocks could linger. Pending any clear signal from the Fed, the markets should continue to see-saw, with sellers in charge of the action, according to some strategists. "Until there is evidence that slower growth will contain inflation, market price movements will probably be quite 'choppy,'" wrote Gordon Fowler, chief investment officer of the Glenmede Trust Co., in a June 12 report.

The Fed is widely expected to raise the federal funds rate to 5.25% when it meets June 28 and 29. Its next step after that is anybody's guess. Fed Chairman Ben Bernanke and other policymakers have sounded a hawkish note on inflation in recent speeches. On June 12, Dallas Fed President Richard Fisher noted the central bank is feeling "some angst" over the issue.

Nevertheless, inflation fears may be overdone, some analysts maintain. Gold prices, traditionally an indicator of inflation, have fallen sharply after surging earlier this year. On June 13, gold fell to $566.80, its lowest level since March and down 22.6% from a 26-year high of $732 reached May 12.

Energy prices, too, have been on the downswing. Oil futures fell to $68.56 a barrel on June 13, after hitting a record $75.35 in April. Meanwhile, the International Energy Agency recently lowered its forecast for global oil demand in 2006 to 1.24 million barrels a day, down 30% from its projection in January.

GROWING PAINS.  A key wholesale inflation reading came out in line with Wall Street expectations on June 13, with data on consumer prices due on June 14. Figures so far in the second quarter suggest inflation is moderating, according to John Ryding, chief U.S. economist at Bear Stearns. "If consumer spending continues to grow at the slower pace in June, the Fed may be encouraged to take no action in August and wait for data on the strength of the third-quarter economy," Ryding notes.

Indeed, some market watchers say concern about growth, not inflation, is what's actually roiling markets. " 'Growth fears' are driving the markets lower," Citigroup analyst Albert Richards wrote in a June 12 report. "The market seems to be thinking that growth (and earnings) may well suffer as a result of the inflation fight."

Others say the recent global downtrend stems from a reassessment of the risks in various asset classes after a long period of rosy outlooks. The market has simply been pricing in the uncertainty about the Fed's plans, explains Joseph Battipaglia, executive vice-president and chief investment officer at Ryan Beck & Co. "Investors shouldn't go for the head fake that there's a recession looming, but rather, that certain markets are cheaper than others, that the Fed will not aggressively move higher on rates, that the inflation surge will subside, and the economy can continue to expand into 2007," Battipaglia says.

SIDELINE SAFETY.  From a technical standpoint, stocks don't seem to have touched bottom yet, analysts say. Leading up to the Fed meeting, expect anxiety to continue as markets zig-zag lower in volatile trading, says Chris Johnson, managing quantitative analyst at Shaeffer's Investment Research. "Until we see buyers start to enter into the fray, the market's not going to have much stability under it," he says.

In the meantime, investors might want to consider the safety of the sidelines. "Now's not a bad time to get a little bit more defensive," says Bill Larkin, portfolio manager of fixed income at Cabot Money Management. He says raising cash levels and taking advantage of high short-term bond yields could be smart moves within a well-diversified portfolio.

The winners of the past few years — such as emerging markets, energy stocks, and small-cap stocks — will continue their recent downtrend, predicts Jeffrey Knight, chief investment officer of global asset allocation at Putnam Investments. "This isn't a run-of-the-mill correction," Knight says. "This is a very important transformational event."

LARGE CAPS, LONG TERM.  As volatility continues, Knight likes cash and Treasury bonds. After the dust settles, he recommends an emphasis on large-cap stocks and stocks with high dividend yields.

Indeed, many market pros favor relatively stable U.S. large caps. "We would be wary of small caps, and we would prefer larger caps at this juncture," wrote Tobias Levkovich, chief U.S. equity strategist at Citigroup, in a June 9 report. Stocks he likes include United Technologies (UTX ), Federated Stores (FD ), Johnson & Johnson (JNJ ), General Electric (GE ), Wal-Mart (WMT ), Caterpillar (CAT ), Merrill Lynch (MER ), and Cisco Systems (CSCO ), among others.

Investors generally shouldn't try to time the market, because they'll tend to lose, others say. "Ordinary investors shouldn't really change from what their long-term strategies are," says Stewart Beach, senior vice-president at Old Second Wealth Management. "If you were waiting to add money to equities, take the volatility as an opportunity. If you were thinking of changing your allocation to having 40% stocks instead of 50%, you take this weakness to be gradually adding in." If you take that tack, just be more defensive to avoid getting hurt.

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