Wall St. Finds Mixed Blessing in Job Growth

The stock market is finally getting what it wanted, as the economy begins to show robust job growth.

The question is whether that could become too much for investors to handle, if it also means that interest rates are about to rise sharply.

Until Friday’s government report on March employment, one of Wall Street’s biggest concerns was that meager hiring was threatening the economy’s recovery -- and President Bush’s reelection chances.

The addition of 308,000 net new jobs last month, the most in nearly four years, has damped those worries for now.

“The jobs report finally provides solid evidence to all that the economy is recovering at a good pace and will continue to recover,” said Tom Hanson, portfolio manager at Pacific Global Investment Management Co. in Glendale.

But with faster employment growth also comes the fear that interest rates could rise substantially from what have been extraordinarily low levels over the last 20 months.

Historically, stock prices have been most affected by two forces: corporate earnings and interest rates. Investors buy stocks for their earnings potential. But the prices investors pay are influenced by interest rates, such as on Treasury bonds, because interest-bearing securities provide competition for stocks.

On Friday, stock and bond markets went their separate ways after the jobs data were reported. The Dow Jones industrial average rose 97.26 points, or 0.9%, to 10,470.59, and other key indexes gained between 1% and 2.5% in a broad rally.

By contrast, some investors dumped bonds, driving the yield on the 10-year Treasury note, a benchmark for other long-term rates, to a two-month high of 4.14% from 3.88% on Thursday. It was the steepest one-day jump in the yield since March 1996, according to Bloomberg News data. (As bond prices fall, their yields rise.)

The stock market was able to look past the surge in bond yields in part because Bush’s chances in the November election are expected to improve if job growth fades as a campaign issue, said Ned Riley, investment strategist at State Street Global Advisors in Boston.

One of investors’ key concerns about Democratic candidate John F. Kerry is that he might roll back Bush’s tax cuts, including the sharp reduction in the top tax rate on dividend income.

Though stocks were mostly higher Friday, Riley said it was reasonable to ask whether the Dow might have risen a lot more except for worries about interest rates.

The reaction in the bond market reflected fears that the Federal Reserve might begin to tighten credit by late sum- mer, responding to economic strength, analysts said. The Fed has been holding its benchmark short-term interest rate at a generational low of 1% since June. If that rate starts to rise, all interest rates could go with it.

With major stock indexes just modestly in the black for the year to date -- thanks to a late-March rebound that followed six weeks of mostly falling share prices -- a lot may be riding on whether Friday’s momentum continues in the near term, some experts say. If it doesn’t, investor sentiment could quickly sour again.

Wall Street bulls are counting on corporate earnings reports to buttress the case for stocks.

Profit growth is expected to be strong: Operating earnings (results excluding one-time gains or losses) of the blue-chip Standard & Poor’s 500 companies rose 16.9% in the quarter just ended, according to analysts’ estimates compiled by Thomson First Call in Boston.

The March employment report showed that the continuing improvement in corporate profitability finally is beginning to translate into new jobs, said Gary Thayer, economist at brokerage firm A.G. Edwards & Sons in St. Louis.

“It’s not surprising that companies can feel a little more comfortable hiring workers now,” given profit gains, he said.

But if analysts’ estimates for the first quarter and subsequent quarters are on target, earnings growth for the average blue-chip firm is decelerating. In other words, earnings overall still are rising, but the year-over-year percentage gains are slowing.

The S&P; 500 companies’ results were up 28.3% in the fourth quarter of last year. By the third quarter of this year, growth may be 11.8%, based on estimates compiled by Thomson First Call.

For professional investors, decelerating earnings growth often is a signal to begin lightening up on stocks instead of placing heavy new bets. That may be more of an issue this time because share valuations remain at relatively high levels historically: The average blue-chip stock is valued at about 20 times estimated 2004 earnings per share.

Market bulls, however, say it’s too early to pull away from equities, with U.S. earnings still rising at double-digit rates and with other factors moving in the market’s favor -- the recent downturn in crude oil prices from 13-year highs, for example, and increasing signs that Japan’s economy is reviving.

“I still think you buy into a market like this,” Riley said. But investors’ focus, he said, is certain to shift to companies that could be poised to deliver the strongest profit growth.

Friday’s rally was led by stocks of heavy-industry, basic-materials and technology companies -- three sectors that would be expected to benefit if the economy’s recovery stretches into 2005 and perhaps beyond.

Some classic growth-stock sectors, such as biotechnology, also were hot Friday.

The optimistic case for stocks is that faster job growth would keep consumer spending at healthy levels, in turn boosting demand for machinery, chemicals, computers and other things needed to produce goods.

In effect, investors are betting on a return of the so-called virtuous circle of the 1990s: more jobs mean greater demand for goods and services, creating more jobs, creating more demand, etc.

The circle could be broken, however, if interest rates were to rise high enough to begin choking off consumer and business spending.

Many analysts believe that those fears are overblown. Some say that despite the large number of jobs created in March, a closer look at the employment report showed signs that the labor picture isn’t totally rosy. And the Fed, they say, won’t begin to tighten credit until it believes that job growth is sustainable, barring a surge in inflation.

“I think the March report was telling us we have a long way to go in terms of healing the labor market,” said Ethan Harris, economist at Lehman Bros. in New York. “We still [see] the Fed on hold until the first part of 2005.”

The market’s judgment on Friday, based on trading in interest rate futures, was that the Fed would begin to raise rates by the end of September, analysts said. But at most, the Fed’s target rate could be at 1.5% by the end of this year, many economists say.

Robert Bender, president of investment firm Robert Bender & Associates in Pasadena, said he wasn’t sweating the prospect of higher interest rates, given the outlook for economic and corporate earnings growth this year.

Even if the 10-year Treasury note yield were to reach 4.5% this year, Bender said, he judges “fair value” on the Dow index to be in the 12,000 to 13,000 range if earnings come through as expected.

“Rates right now are not the important thing. It’s growth,” Bender said. “This economy is a 12-cylinder car operating on all 12 cylinders.”

The 1990s experience also soothes market bulls: The economy and the stock market coped well with much higher interest rates in the last decade. And last summer’s sharp rebound in bond yields didn’t derail the economy or stocks.

Generally, “the market doesn’t like higher interest rates,” said Fritz Reynolds, manager of the Reynolds Fund in Larkspur, Calif. But investors may be prepared for rates to move up somewhat if economic strength is driving them, he said.

The old line on Wall Street, Reynolds noted, is “three steps and a stumble” -- meaning three Fed rate hikes and the stock market falters. “But with rates so low,” he said, “maybe you could argue it’s something like ‘five steps and a stumble’ now.”