Pitfalls Awaiting the Bulls

Profits, Oil and the Fed
Threaten to Put an End
To Lengthy Stock Rally
September 16, 2005

Many on Wall Street think the three-year old bull market has enough life left to carry the Dow Jones Industrial Average to 11000, a level unseen in more than four years. But there are serious reasons why the bulls' time at the summit might be short. Guest columnist Jim Paulsen, chief investment strategist at Wells Fargo, however, thinks worrying about housing, oil prices and the Federal Reserve amounts to missing the forest for the trees.

This Too Shall Pass

Sometimes it is hard to believe a streak will end. New York Yankees fans swallowed a hot cup of "D'oh!" when the Boston Red Sox last year ended an 84-year streak without a World Series title, humiliating their archrivals in the process. Corporate profits have been on their own eye-popping tear, the end of which could be equally jarring.

Standard & Poor's 500-stock index profit growth has posted double digit-gains for eight straight quarters, the fourth-longest streak since Thomson Financial started keeping track in 1950. If nothing else, mathematics would seem to dictate an eventual decline, but many don't see it yet, despite the obvious profit hit coming from Hurricane Katrina.

Wall Street analysts expect double-digit growth well into 2006, according to Thomson -- including 17.2% in the current quarter. The third-quarter profit-warnings Wurlitzer is just getting cranked up, and there will be many Katrina-related tales of woe from various companies. But only an unexpectedly "dramatic" hit from Katrina would leave third-quarter profit growth below double digits, according to Thomson analyst John Butters.

But there are pitfalls waiting for corporate profits. Oil, gasoline and natural gas were pricier than a Florida condo even before Katrina. High energy prices, along with the economic stimulus of rebuilding, might inspire the inflation-fearing Federal Reserve to make borrowing costs more expensive.

A slowdown in housing could hurt confidence and the ability to use the family split-level as an ATM. In an ominous sign that high gasoline prices could be sapping demand, gas consumption fell last week despite the Labor Day holiday. "The economy will at best muddle," says Jeffrey Saut, chief investment strategist at Raymond James, who foresees "single-digit" earnings growth and a stock market firmly staying the course to nowhere.

Meanwhile, businesses are finding it harder to cut labor costs by pushing workers harder, outsourcing jobs to Lower Wagistan or replacing employees with fancy robots. "Companies are paying more compensation and getting less productivity growth," says Ethan Harris, chief economist at Lehman Brothers, who wouldn't be surprised to see corporate-profit growth next year slow to 6% or 7%. That wouldn't be the end of the world, but it may mean the Dow industrials won't spend much time, if any, above 11000.

And stocks are just too heavy for such rarified air. Adjusted for inflation, the S&P 500 currently trades at roughly 26 times the prior 12 months' earnings, according to data compiled by Yale professor Robert Shiller.

When the bull market began in 1982, stocks traded at a puny seven times real earnings, according to Mr. Shiller's data. So, more P/E compression might be necessary to get stocks ready for another launch back into the stratosphere.

Scott Patterson: In most mysteries, the brooding guy with the scar and limp isn't the villain -- it's the clean-cut guy you have to worry about. Judging by the stock market's performance after Katrina, bullish investors may be mistaking which role the Federal Reserve will play over the coming months.

The Dow Jones Industrial Average rose 281.27 points in the two weeks after the hurricane, an unexpected rally borne partly out of faith that the Fed will take a break from raising interest rates when policy makers meet Sept. 20. In the storm's immediate aftermath, Wall Street put the chances of the Fed pausing at about 50%, according to trading in federal-funds futures contracts. Since then, hopes for a pause have faded, but there is still uncertainty on Wall Street.

In reality, there is a group on Wall Street that believes the Fed will remain aggressive in raising rates through the end of the year. Some economists think policy makers will boost rates at all three of the remaining meetings this year and continue tightening the screws on monetary policy in 2006. Peter Hooper, chief U.S. economist at Deutsche Bank and a former Fed governor, thinks policy makers will keep lifting rates into 2006 until they reach 5%.

That, some analysts say, could end the bull market's three-year charge. James Smith, chief economist for the Society of Industrial and Office Realtors, says you can "bet on a near-term recession" if the central bank lifts rates to 5% next year.
A recession may or may not be in the cards, but investors will certainly fret if interest rates keep marching higher, especially if the housing market loses some froth and consumers get squeezed by gasoline and home-heating bills, and by punishing credit-card fees because the Fed raised rates too far.

If history is any guide, there could be one last rally for stocks. Sam Stovall, chief investment strategist at Standard & Poor's, says that in the prior eight tightening cycles, the S&P 500 had climbed an average 5.3% in the three months prior to the final rate increase. The post-Katrina rally could be a sign some sense the final increase is on the way. Bill Strazzullo, chief trading strategist at State Street, thinks the S&P 500 could climb as high as 1300 by December, but says that would be "a high-water mark" for the next two years.

Another Spurt to Come

David Gaffen: In the days after Katrina, stock investors celebrated as crude oil seemingly hit a peak of $70 a barrel. But some market watchers are warning it is too soon to cheer since the impact of oil's first forays to $60 and $65 months ago hasn't even reverberated through the economy yet.

The International Strategy and Investment Group, a Washington-based research group, issued a report in late August that said the full effect of a sustained spike in oil prices doesn't truly work its way through the economy for about year. Companies that initially absorbed high prices start to raise costs and consumers finally start cutting back. "Those sorts of decisions take time to make," says Josh Shapiro, economist at MFR. Companies. "They have some period of time where they watch and look for signals, and then behave accordingly."

That poses a sort of Double Jeopardy for the stock market: First investors first react to energy-market fluctuations, and then they get to react months later when companies like DuPont raise prices across the board and consumers hold back on discretionary spending because their tabs are too high at the pump.

If the ISI is right, oil's ascent to $40 and $50, which took place between the second half of 2004 and the first quarter of 2005, is still working its way into the economy in the form of higher production costs, corporate-profit warnings, rising prices at the pump and potentially costly home-heating bills around the corner.
TEC International, a consulting firm, said this week that nearly half of some 2,000 CEOs polled in early September said energy costs were their chief concern, more than double the number who said that in the second quarter.
Last month, a few companies, most notably Wal-Mart, started to finally openly fret about oil. Analysts at Credit Suisse First Boston wrote this week that the energy bite out of personal income now amounts to 3.5%, a rate roughly equal to the late 1970s and worse than the 2% to 2.5% range between 1986 and 2003.

Sure, $65 oil is better than $70. But when the market eventually contends with the real force of $70, investors' joy will turn as sour as crude itself: "Nobody's saying those prices are a windfall," says David Joy, capital markets strategist at RiverSource Investments, part of Ameriprise Financial.

Don't Buy the Gloom

James Paulsen, Wells Fargo: There are endless stories on Wall Street about when the housing bubble will burst, whether oil prices will cause the consumer to capitulate and whether Fed tightening will slow corporate profit growth.

Investors should instead be relishing the positives.

The global economic recovery appears healthy, sustainable and far more widespread than the last recovery, when the U.S. was the sole growth engine. Inflation and interest rates remain surprisingly low during a time of solid real growth. Corporate profits have risen by more than 17% in the last year and quarterly earnings reports have chronically outpaced expectations since the beginning of 2003. The consumer looks strong: relatively high confidence, less than 5% unemployment, record-high net worth, strong growth in labor compensation, solid retail sales and near record-high housing activity.

Overall economic policy remains accommodative despite regular increases in short-term interest rates over the last year. Adjusted for inflation, the current federal-funds rate is barely above zero, long-term yields haven't risen in this recovery, already-pronounced fiscal stimulus is about to expand and the dollar remains weak.

This stock-market cycle is still early:
In 2000, the S&P 500 traded at about 27 times the prior 12 months' earnings.
Today, the trailing P/E is 19 and looking forward a year, the S&P 500 trades at a P/E of 16.

A number of near-term catalysts could initiate a fresh run:
Robust demand from China and a rebound in euro-zone economies keep corporate profits robust, overpriced oil continues to fall after Katrina, businesses spend their cash hoards or the trade deficit improves.