Monday, August 21, 2006

Can the Rally Keep Up?

News Analysis
August 21, 2006

Business Week Online

Can the Rally Keep Up?

Stocks have risen to their highest levels since May. Sentiment has turned positive, but uncertainties remain, analysts say

It looks as if stocks have finally have shaken off the summertime blues. In the week of Aug. 14, a Mideast ceasefire and mild inflation data helped stocks climb to their highest levels since mid-May. The major indexes pieced together five straight days of gains, with the Dow Jones industrial average finishing the week up 2.6% and the tech-heavy Nasdaq composite index surging 5.1%.

Indeed, some market watchers have been calling for a summer rally. But can it last?

The bulls insist that the winds of investor sentiment have shifted for the better. "Right now the path of least resistance is higher," says Steve Sachs, director of trading at Rydex Investments. "The market is pricing in that 'Goldilocks' environment. We just don't have enough data to know if that's actually the case yet."

Still, with plenty of economic figures pending and about a month to go before the next Federal Reserve meeting, inflation hawks and investors worried about a slowing economy are staying on high alert. "The market is a little ahead of itself, and I suspect we're in for some sort of pullback," says Peter Cardillo, chief market analyst at S.W. Bach.

GOOD NUMBERS.  Some recent economic data have gotten positive spin. On Aug. 15 the Labor Dept.'s producer price index came in softer than expected for July. Another closely watched inflation gauge, the consumer price index, provided more tame numbers a day later. The info lent support to the Federal Reserve's Aug. 8 decision to keep interest rates steady on the premise that a slowing economy would reduce inflation pressures (see, 8/16/06, "Is the Fed Out of the Picture?").

A week earlier, the Fed's long-awaited pause wasn't enough to send stocks higher on its own, as an accompanying policy statement left the door open to more rate hikes (see, 8/8/06, "The Pause That Perplexes"). "The market's been missing something," says Chris Johnson, managing quantitative analyst at Schaeffer's Investment Research. "The last two reports that we've seen were supportive of what the market's been looking for."

Unfortunately, the latest inflation figures don't entirely remove interest-rate uncertainty, either. Economists and investors continue to disagree over whether upcoming data will force policymakers to tighten at the Sept. 20 Federal Open Market Committee meeting or later this year, notes the Standard & Poor's Investment Policy Committee (see, 8/8/06, "Bulls Win, Bears Lose").

CRUDE RELIEF.  Plus, even if the Fed is done tightening rates, the world's other central banks may not be. On Aug. 18, China raised its key rates by 0.27 percentage points, following hikes by Iceland and Norway earlier in the week.

One factor that might keep inflation under control is a decline in energy prices. On Aug. 17, three days after a truce began between Israel and Hezbollah, September West Texas Intermediate crude oil futures dropped to a new two-month low of $70.06 a barrel, before closing the week at $71.14.

Further softening in oil prices could propel stocks to fresh gains while keeping the Fed's foot off the rate-hike pedal, analysts say. "If we have any continuity in the economic data stream and a continuation of lower energy prices, I think we can have three weeks of rallies, instead of three days," says Art Hogan, chief market analyst at Jefferies & Co.

HOUSING DRAG.  On the other hand, there's also concern the Fed may have slowed the economy too much, paving the way for a hard landing. Investors will get a fuller picture of the economy the week of Aug. 21 with reports on durable goods orders along with new and existing home sales (see, 8/18/06, "Vital Signs: Dog Days for Housing"). The next readings on wholesale and consumer inflation aren't due until mid-September.

The cooling housing market continues to loom as another potential drag on the economy (see BusinessWeek, 8/21/06, "Why Housing Looks a Little Rickety"). Some analysts are unconcerned, however. "We don't expect the falloff to cause an economywide recession, or much of a slowdown," says Ed Yardeni, chief investment strategist at Oak Associates, in an Aug. 18 dispatch.

From a technical standpoint, indicators suggest stocks may keep moving higher, analysts say. The market could be "in the early stage of a tradeable uptrend that carries the potential of testing the early May highs for the major indexes," says Richard Dickson, senior market strategist at Lowry's Reports.

FEW CATALYSTS.  Which stocks will stand out? Some analysts expect large-cap stocks to continue to beat small-caps, as they have since May. "It's just the start of large-cap outperformance," says Goldman Sachs strategist David Kostin in an Aug. 18 note, citing strong second-quarter earnings and upward revisions to 2006 and 2007 forecasts.

More specifically, some market watchers continue to expect defensive sectors to outperform, despite recent strength in technology stocks. Utilities, health care, and consumer staples all remain attractive, according to Jack Ablin, chief investment officer at Harris Bank.

Nevertheless, the last two weeks of August tend to be quiet as investors take vacations before school starts. With earnings season in the rearview mirror, stocks will have fewer likely catalysts for major movements. And some analysts aren't convinced the summer doldrums are over. "I'll take the last few days," says Jay Suskind, co-head of capital markets at Ryan Beck. "But two or three days don't make the market."

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