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MAY 24, 2004
The Funk On The Street Sure, the economy looks strong. But Iraq, high oil prices, and looming rate hikes are weighing down the market Charles De Vaulx is sitting atop a big pile of cash. Right now, the co-manager of First Eagle Funds doesn't like what he sees: rising interest rates, a worsening situation in Iraq, and what he considers an overvalued stock market. Around 23% of his fund is in the green stuff, vs. as little as 6% during the bull market in 1999 and early 2000. "A lot of companies -- some 30% of the Standard & Poor's 500 -- have benefited greatly from low interest rates," de Vaulx says, adding that the buffer is coming to a fast, possibly brutal, end. He has plenty of company in shunning equities these days. On May 10, stocks fell to their lowest point this year as investors rushed to bail out. That day, the Dow Jones industrial average was down 1.3%, falling below 10,000 for the first time since last December. The S&P 500-stock index and the NASDAQ were both down some 1%. Abroad, it was worse: Japan's Nikkei cratered 5%, and the European markets all sank 2% to 4%. The following two days the choppy market regained a few points. Some might call de Vaulx and his compadres big bears. After all, the economy is humming along at a healthy 4% pace, producing more jobs and generating sparkling corporate profits. And now that stocks have come down while earnings are way up, many on Wall Street think stocks are again good value. What's more, research shows that, historically, in the year after the Federal Reserve starts to raise rates, the economy grows strongly and stocks rise an average of around 14%. That should be good news for the market. Nonetheless, the boogeyman is beating out the bull for now, and investors are spooked. And their funk could last for weeks, if not months. Interest rates are set to rise as early as late June as the Fed begins a sooner-than-anticipated tightening cycle. Oil prices continue to be sky-high, topping $40 a barrel and threatening to eat into corporate profits. In late April, Fed Chairman Alan Greenspan warned that oil could stay pricey for several years and act as a big damper on business investment. Many investors, particularly Europeans, increasingly see Iraq as a quagmire. That, and the growing U.S. budget deficit, are raising questions in their minds about whether President George W. Bush can win a second term in November. Some investors fear that if Bush's challenger, Senator John F. Kerry (D-Mass.), wins, he would reverse Bush's tax cuts and deal a blow to the economy. Even if Bush prevails, many strategists worry that his earlier economic stimulus -- including capital-gains tax and dividend cuts -- has already largely run its course. `A BADLY BEATEN BOXER' Suddenly it's a "woe is me" market. Indeed, Ned Davis Research Inc.'s "Crowd Sentiment Poll," which measures U.S. investor confidence, has fallen from 76% at the beginning of the year to 51% as of May 12. At the same time, foreign investors have fallen out of love with equities and overseas markets have gone south. According to Mamoru Yamazaki, chief economist with Barclay Capital Research in Tokyo, foreign investors have been selling Japanese stocks, which had a big run-up earlier this year but are now down. The possibility that China's red-hot economy may slow has given investors a reason to dump the stocks of Japanese exporters that benefited from it. They've taken profits, expecting to buy U.S. Treasuries when yields rise. In Europe, markets have also been uneasy. Andreas Hürkamp, stock market analyst at Landesbank Rheinland-Pfalz in Mainz, Germany, says investors are unnerved by the strength of the U.S. recovery because it almost certainly means that European interest rates won't be cut as hoped. High oil prices and Iraq are also concerns. The DAX, Germany's index of 30 leading stocks, is like "a badly beaten boxer staggering round the ring," he says. But it's the realization that interest-rate hikes will happen a lot sooner than most had expected that has really fazed markets. "Investors are saying, 'It's actually going to happen this time,"' says Timothy Hayes, senior stock strategist at Ned Davis Research. That conviction became strong when May 7 employment data showed 288,000 jobs were created in April. Immediately, bets in the futures market suggested that the Fed would raise rates by 25 basis points, or one-quarter of a percentage point, at its June 29-30 meeting. "The stock market tends to overreact at the start of a tightening cycle because people worry that the economy won't be able to sustain its growth rate with higher rates," says Merrill Lynch & Co. (MER ) economist Ron Wexler. Hedge funds and large institutions have also made big bets on "carry trades". That's when investors borrow short-term money at low rates and put it in higher-yielding instruments such as longer-term Treasuries. Now, investors are unwinding these trades, adding to carnage in the bond market and putting pressure on financial stocks. Some analysts fear that the Fed has kept rates too low for too long. The federal funds rate -- at which banks lend to each other overnight -- has been 1% for almost a year and is below today's 2% inflation rate. If the Fed is indeed behind the inflation curve, a 1994-style scenario could result. Then, Greenspan hiked rates from 3% to 6% over 12 months. Stocks headed south, and bond markets turned bloody. But most experts say it's doubtful that Greenspan would make the same mistake twice. In fact, the Fed has said that it would raise rates at a measured pace in part because inflation is expected to remain low. Although investor sentiment is negative, economic fundamentals remain positive. And many pros see a significant opportunity in that divergence. James W. Paulsen, chief investment strategist at Wells Capital Management in Minneapolis, for one, thinks it's a good time to buy stocks. "Profits are rising, GDP is rising along with top-line growth. I like staying on the reality -- the sentiment will come around," he says. INFLECTION POINT Surprisingly, when rates do start to rise, stocks tend to fare better than you might think. According to a study by Merrill Lynch of the two decades since 1983, the market has generally fared well in a tightening cycle -- rising at an average of 14.3% a year, with the bulk of the gains coming early on. The reason: When the Fed starts to raise rates, the economy and profits are typically growing strongly. Indeed, it's not until well into the year after the first rate hike that the economy starts to decelerate, and the stock market takes a hit, according to Merrill. Corporate profits are right on track with that optimistic scenario. So far, 454 companies in the S&P 500 have announced first-quarter results, and their earnings are up 27% over last year, according to Thomson First Call. The rest of 2004 doesn't look so bad, either. Although year-over-year profits comparisons are getting more difficult, analysts expect earnings of the S&P companies to grow 17% over 2003. Sectors such as basic materials, which are extraordinarily sensitive to the economy, are racking up profits even faster than others, as are blue-chip technology and consumer-driven stocks. Many investors believe that stock valuations are high. In reality, they're not. The S&P is trading at around 17 times estimated earnings for the next 12 months. That is slightly above the historical average of around 15. Effectively, however, it's very close to the average after allowing for the premium at which stocks trade when interest rates are low. All the same, some observers still think stocks are overvalued because future earnings are unlikely to be as strong as analysts are forecasting. "There will be big segments of the economy where rising rates will eat into profits," says First Eagle's de Vaulx. The convergence of all this good news (a growing economy and profits) and bad news (rising rates and geopolitical worries) has led to what many strategists call "an inflection point" in the market. That's when stocks either start to go up or go down. Right now, few analysts are brave enough to call which way the market will jump. But it's unlikely that 2004 will be a repeat of last year, when the stock market soared 25%. This year, the woe is me market could hang around for a while.  By Marcia Vickers in New York, with Peter Coy in New York, Brian Bremner in Tokyo, and David Fairlamb in Frankfurt
BW MALL
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