Saturday, September 23, 2006

An Autumn Chill for Stocks

News Analysis
September 23, 2006

Business Week Online

An Autumn Chill for Stocks

Major indexes approached all-time highs, then suffered a two-day decline on economic jitters. Where do they go from here?

The late-summer rally is fading, and stocks are feeling a seasonal autumn chill. On Sept. 20 major indexes notched their best closing levels since early May and pulled within striking distance of new records.

The Dow Jones industrial average, for one, rose to around 100 points shy of its all-time closing high of 11,722.98. Then worries about slowing economic growth helped send stocks down for two straight sessions, as Wal-Mart's (WMT ) generic-drug discounts and Hewlett-Packard's (HPQ ) leak probe fallout also weighed on the market (see, 9/22/06, "HP's Hurd on the Hot Seat"). On Sept. 22 the Dow fell to 11,508.1, the Standard & Poor's 500-stock index dipped to 1,314.78, and the Nasdaq composite landed at 2,218.93.

An uncertain economic outlook and the prospect of dwindling corporate earnings could keep investors in a cold sweat heading into the November elections and possibly beyond, analysts say, despite lower energy prices and a calmer geopolitical climate. "The actions of equity investors over the past three days tell us that it is likely that the equity jitters will continue for at least the first part of the fall," says Brian Reynolds, chief market strategist at M.S. Howell.

Recent economic reports have added to investors' worries. On Sept. 21 the Philadelphia Federal Reserve index skidded to -0.4%, down from 18.5 in August. It was the regional business activity gauge's first negative reading since April, 2003. "The negative report is very discouraging for manufacturing," says Beth Ann Bovino, senior economist at S&P. The next report on national manufacturing activity, the Institute for Supply Management's purchasing manager's index, on Oct. 21, should show whether the Philly Fed was an aberration.

TREASURY TROUBLE.  The Federal Reserve's policy on interest rates hasn't provided much relief either. On Sept. 20 the Fed kept interest rates steady but declined to rule out further interest rate hikes (see, 9/20/06, "Bernanke's Steady Course Cheers Markets"). In its policy statement, the central bank said inflation worries remain even amid a slowing economy. The comments were less sanguine about inflation than expected, says Action Economics, and Treasury yields ticked higher on the news.

Indeed, the Fed may have still have more rate-hiking to do, some analysts say. "There is clearly a lingering concern regarding the current level of inflation that is being weighed against possible downside growth risks related to housing," says Lehman Brothers economist Drew Matus.

At the same time, the Fed signaled that the housing market's slowdown is more rapid than previously anticipated. Policymakers removed the word "gradual" from the Fed's description of the housing slowdown, following a drumbeat of disappointing data (see, 9/8/06, "Builders Brace for a Housing Downturn"). Investors await the release of August existing home sales, set for Sept. 25.

LIMITED VISIBILITY.  Other analysts say the housing market weakness could drag down the economy and force the Fed to start cutting interest rates early next year. "The U.S. demand slowdown is poised to come sooner and prove more persistent than generally expected," says Merrill Lynch's global economics team in a Sept. 18 report. And some extreme pessimists see signs of a recession (see, 9/18/06, "The Gloomy Side of the Street").

If the economy slows, corporate profits could decelerate with it. S&P 500 companies have posted 17 straight quarters of double-digit earnings growth, leaving some analysts wondering how long the streak can last. Earnings visibility for 2007 "remains murky," according to notes from the S&P Investment Policy Committee meeting on Sept. 21 (see, 9/22/06, "Significant Slowing for Economy in 2007").

Investment banks Goldman Sachs (GS ), Lehman Brothers (LEH ), and Morgan Stanley (MS ) already kicked off the current third-quarter earnings season with solid results. However, on Sept. 21, a strong earnings report from FedEx (FDX ) was accompanied by a lower-than-expected outlook. Meanwhile, companies like Yahoo! (YHOO ), Dow Jones (DJ ), and New York Times (NYT ) have issued third-quarter profit warnings.

SOFTER OIL.  Nevertheless, the global economy may allow corporate profits to stay strong even as U.S. economic growth moderates, others say. "The connection between corporate profits and national GDP is becoming much weaker," says Daniel Chung, president and chief investment officer at Fred Alger Management.

On the bright side, the threat of $100 oil seems like a distant memory (see, 9/11/06, "Will Oil Stay Soft?"). Prices for oil and other commodities have fallen in recent weeks, with November West Texas Intermediate crude oil futures settling at $60.55 on Sept. 22.

The November elections may also provide a bullish factor (see, 9/21/06, "A Game Plan for D.C. Gridlock "). Stocks have tended to post their best returns in the fourth quarter of previous midterm election years. Still, some analysts question whether past election-cycle performance continues to have predictive value.

AVOID CONSUMER ISSUES.  "The frequency of the discussion surrounding the four-year cycle is likely to cause it to play out in a much different fashion from what most imagine," says Morgan Stanley technical analyst Mark Newton. "We remain skeptical that the yearly lows were made in the June/July period, and suspect that pullbacks could unfold over the next few months."

In a slowing economy, investors should avoid stocks of companies that depend on domestic consumer spending, including many retail, restaurant, housing and auto-related stocks, says Brian Belski, U.S. sector strategist at Merrill Lynch, in a Sept. 22 report. Belski prefers stocks that should benefit from capital expenditures, a weaker dollar, or a favorable commodity outlook, including 3M (MMM ), Caterpillar (CAT ), Intel (INTC ), and Exxon Mobil (XOM ).

With the Dow sitting within 215 points of its peak, major indexes could get another shot at record heights. Still, how far stocks can rise depends on how softly the economy lands, and that remains anybody's guess.

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