Wednesday, October 11, 2006

Nightmare on Wall Street

News Analysis
October 11, 2006

Business Week Online

Nightmare on Wall Street

With Halloween approaching, here are five factors that experts say could frighten the markets, even as the Dow hits all-time highs

On Oct. 9, North Korea spooked investors by announcing its first successful test of a nuclear weapon. Asian indexes tumbled, while European markets fell at the outset before finishing mixed. In the U.S., major indexes gained slightly despite overnight losses (see, 10/9/06, "Dow Hits New High Despite North Korea Tests").

North Korea's nuclear saber-rattling might not have been enough to derail the Dow Jones industrial average's recent run toward record heights. Still, stocks face more than enough potential bogeymen to keep investors up at night.

In the spirit of the upcoming Halloween holiday, this week's Five for the Money looks at five factors that experts say could make mischief for the markets.

1. Haunted Housing
To be sure, the slowing housing market is already giving investors frights. The PHLX Housing Sector index is down 17% for the year through afternoon trading Oct. 11. Federal Reserve Chairman Ben Bernanke recently said he expects the housing downturn to shave 1% off economic growth this year and possibly next.

But what if housing's horrors turn out to be even worse than expected? An unexpectedly sharp slowdown could be a downside risk for the market, analysts say. Worse, the unpleasant surprises may have already begun. "Although our outlook for housing has been among the pessimistic of economic forecasters, the correction thus far has been deeper than we expected," Goldman Sachs (GS ) economist Ed McKelvey says in an Oct. 9 note.

Since 1994, the Standard & Poor's 500 index has tended to follow the direction of the National Association of Home Builders' housing market index about a year later. Recent declines in the homebuilder confidence gauge may suggest tough times ahead for stocks, according to Liz Ann Sonders, chief investment strategist at Charles Schwab (SCHW ). Sonders suggests investors remain about 5% underweight on domestic equities in favor of cash.

"There is still likely more pain and suffering to come before we can close the books on this housing cycle," Sonders says in a Sept. 21 report. "And the harder housing falls, the harder it will be for the economy to land softly."

Still, some see the weakness confined to housing, while others maintain the worst could be over (see, 10/10/06, "The Dust May Be Settling for Homebuilders"). Gains in nonresidential and public construction spending have offset the drop in residential construction, according to Ed Yardeni, chief investment strategist at Oak Associates. "Will the housing market lead to an economy-wide recession?" Yardeni asks in an Oct. 10 note. "Not in our forecasts."

2. Earnings Fears
These have been fat times for corporate profits. The S&P 500 recently posted its 17th consecutive quarter of double-digit percentage earnings growth, a streak S&P projects will continue in the third and fourth quarters. While Wall Street expects the celebration to roll into 2007, a slowing economy has made some analysts skeptical (see, 9/15/06, "Both Can't Be Right").

Declining commodity prices and cooling economic growth may cause earnings to decelerate next year, analysts say. "Nominal growth is poised to slow quickly, and with it, the revenue gains of many firms, particularly commodity producers who have enjoyed stunning price gains," says Citigroup (C ) senior economist Steven Wieting in an Oct. 9 note. "We continue to expect a 7.4% gain in S&P 500 EPS in 2007 after a 15.4% rise in 2006."

Disappointing quarterly results from Alcoa (AA) may signal trouble for stocks even sooner. Announced Oct. 10, the aluminum giant's earnings shortfall "questions the sustainability of the recent rally, especially with the Dow at all-time highs," according to market-analysis outfit

3. Recession Risk
If weaker housing or slower earnings growth sound scary, just imagine the market implications should the economy fall into outright recession. Stocks' recent gains notwithstanding, some forecasters say a hard landing is more likely than investors might suppose (see, 9/18/06, "The Gloomy Side of the Street").

The Treasury yield curve is one indicator of possible economic weakness, some analysts say. In afternoon trading Oct. 11, the yield for the 10-year Treasury note was more than 50 basis points below the federal funds rate. "Every time this relationship inverts by more than 100 basis points, we're faced with negative year-over-year job growth and a recession," says Jack Ablin, chief investment officer at Harris Bank.

Bond investors may be well aware of the slowing economy, but a strong corporate bond market suggests they're not predicting a recession just yet, other analysts say. "The Treasury market has been absorbing economic volatility for years now; there is no reason to think that will change," says Brian Reynolds, chief market strategist at M.S. Howells.

4. Inflation Anxiety
Some investors are already looking forward to the possibility that the Fed will cut interest rates sometime next year to spur economic growth. The market will begin to price in this prospect during the fourth quarter, says Jeff Kleintop, chief investment strategist for PNC Advisors (PNC ), in his most recently monthly outlook.

However, there's a risk that the Fed will not cut rates as soon as investors hope, other analysts say. A lack of a rate cut by early 2007 is a serious possibility, and it would hurt both stocks and bonds, according to David Rosenberg, North American economist at Merrill Lynch (MER ).

Fed officials continue to express worries about inflation, which would suggest holding rates steady. The minutes to the Fed's most recent monetary policy meeting, released Oct. 11, indicate many policymakers remain "quite concerned about the outlook for inflation." On Oct. 9, San Francisco Fed President Janet Yellen said, "Core consumer inflation has been uncomfortably high recently," though she projects inflation to decline in the medium term.

Other analysts also tend to see inflation waning next year. But there may be a rise in labor costs or a rebound in commodity and energy prices, according to Sandra Lawson, senior global economist at Goldman Sachs, in an Oct. 11 dispatch. Either way, inflation is one monster that isn't easily swept under the bed.

5. Geopolitical Hobgoblins
In a recent survey, economists named terrorism as the biggest short-term risk facing the U.S. economy (see, 8/29/06, "10 Threats to the U.S. Economy"). While stocks have shrugged off recent terrorist incidents, the broader threat of violence from the Middle East and, most recently, North Korea, still looms as a possible overhang on the market (see, 9/11/06, "September 11's Lessons for Investors").

Conflict with Iran is one worry, says PNC's Kleintop. Indeed, much of stocks' recent rally has followed the August ceasefire between Israel and Iran-backed Lebanese militant group Hezbollah. Energy prices have also tumbled since the ceasefire.

On the other hand, some analysts say it would take a particularly dramatic event for fears of terrorism or rogue states to further impact the market. "The threat of terrorism is alive and well, but until there is another massive attack on U.S. soil, it is unlikely to kill the present risk preference of world financial markets," says research group Ried Thunberg.

While some of these worries could prove to be just ghost stories, investors should be aware of the key risks to their assets. Here's to hoping the only scary things this Halloween season are those bratty teenagers with the shaving cream cans.

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