| My
Thoughts on the Market |
Published: May 10, 2004
After attempting to bounce back from a
late-April pummeling on Monday and Tuesday, the major indices slumped
lower for the second consecutive week. The Dow, S&P 500 and Nasdaq
ended down -1.1%, -0.8% and -0.1% on the week, respectively. Although
those declines might not seem all that significant, keep in mind that
they came on the heels of one of the worst weeks the market has seen in
years. In addition, the market nose-dived sharply lower on Thursday and
Friday, and decliners swamped advancing issues by a disturbingly wide
margin. That sharp decline continued in full force on Monday's session,
as the major indices each slumped at least -1.0%.
Business is Booming, So Why Are The Markets Heading
South?
The U.S. economy and corporate earnings remain on track. For its part,
the economy has grown at an astounding +5.5% average annual pace over
the past nine months. To find a healthier economic performance in a
given nine-month period, you have to sift back through the data all the
way into the days of punk rock, Ronald Reagan and Max Headrom -- in
other words, all the way back to the early 1980s! Meanwhile, corporate
earnings have been on an absolute tear. With over 90% of all S&P 500
components already having delivered first-quarter numbers, the results
so far show an average +25.8% jump in earnings and a +11.7% increase in
revenues.
Despite this positive news, however, the market has
turned tail in recent weeks and the three major indices are now all
firmly in negative territory on the year.
So... what gives?
To understand exactly why the market is selling off
right now (and why it might continue to trend sideways to lower in the
coming months), the first thing we need to realize is that the market is
a forward-looking discounting mechanism. In other words, the market
generally reacts to news well ahead of when it actually occurs --
usually at least a year ahead (or more). Therefore, even though the
economy and corporate earnings are likely to remain robust throughout
the first half of 2005, the market doesn't really care. In fact, Wall
Street already priced in the impact of that boom by sending equity
prices strongly higher throughout 2003. Instead, the market is starting
to price in events that are going to happen in late 2005.
So... exactly what are people expecting to see in late
2005?
Well, the prevailing thinking on Wall Street now is
that the economy and corporate earnings are going to experience a
significant slowdown roughly a year from now. Perhaps not a recession,
but a slowdown in growth nonetheless. This period of more sluggish
growth will be brought on by the following factors:
Higher Interest Rates -- At its regularly
scheduled meeting last Tuesday, the Fed warned the market to expect
higher interest rates later on this year. On the positive side of
things, the Fed indicated that it would move at a "measured"
pace. Yet given the blowout numbers we've seen in recent jobs data, as
well as a number of greater-than-expected inflationary figures as part
of other data releases, the market now expects the Fed to raise rates by
25 basis points (a quarter of a percent) at the end of June and another
25 basis points in August (based on the Fed funds futures). In addition,
an increase of a whopping +1.25% is now forecast by year-end. If the Fed
does indeed move this quickly to raise rates, then the economy will
begin to feel the negative effects sometime late next year.
Declining Economic Momentum -- The economy is
firing on all cylinders at the moment, and many economic variables (such
as the ISM index) have recently registered fresh new highs. However, the
recent momentum we've seen in many of these indicators is starting to
wane. After the economy reaches the peak of its growth cycle, we're
likely to see regular, consistent declines (not necessarily negative
growth, but more sluggish growth) in many economic variables such as GDP
and industrial production. Although the economy is still likely to grow,
bearish observers fear that by this time next year it could be growing
at a much slower clip.
Higher Oil Prices -- Oil prices recently
reached fresh 13-year highs and futures contracts have pointed toward
prices upwards of $40/barrel. Since oil is such an important input into
many goods and services (primarily through its relationship with
shipping costs), it could stoke inflationary pressures in the U.S.
economy. In addition, its direct impact on consumers through higher
gasoline prices could put a damper on consumer spending in the coming
year. What's worse, forecasters now expect oil prices to remain at
historically high levels for the foreseeable future.
Geopolitical Woes / Other Economic Shocks -- A
number of other significant risks remain, including difficulties in
Iraq, terrorist concerns, a possible housing bubble in many major
metropolitan markets, and fears of slowing growth in China. All of these
have the potential to negatively impact future economic growth.
WHERE DO WE GO FROM HERE?
The market has moved sharply lower in recent weeks, and is therefore due
for an oversold bounce. As such, the major indices could post a nice
rally here in the coming days or weeks. However, based on recent bearish
market activity, as well as the risks outlined above, my staff and I now
feel that any future market rallies aren't likely to last very long.
Therefore, we'd urge you to get a bit more defensive with your portfolio
holdings ahead of the impending rise in interest rates.
The best way to ride out a flat to declining market is
to focus on value-oriented plays and non-cyclical sectors. Meanwhile,
you should steer clear of most cyclical and high-tech sectors. In the
table below you'll find a list of areas to invest in, as well as areas
to avoid, in the upcoming period of rising interest rates:
| Little
Impact from Rising Interest Rates |
Most
Likely to be Hurt by Rising Interest Rates |
| Pharmaceuticals/Healthcare |
Financials |
| Consumer
Staples |
Construction
& Housing |
| Non-Cyclical
Sectors |
Consumer Cyclicals |
| Security
Firms |
Bond
Funds |
| Debt-Free
Companies |
REITs &
Utilities |
We'll bring you further guidance on this important
topic and will introduce you to a host of specific strategies that you
can use to help guard your portfolio in the weeks and months ahead, so
please stay tuned.
Good investing!
|
Please Note: The above article was merely a
small excerpt from an issue of our premium, long-term-oriented investing
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