Bulls Still in Control, but Can They Hold On?
The U.S. stock market is meeting expectations this year. Unfortunately for investors, those expectations were pretty dismal to begin with.
Many Wall Street pros predicted at the start of the year that the market would generate single-digit returns at best in 2005.
Here we are, with 12 weeks left to go, and the blue-chip Standard & Poor’s 500 index is down 1.3% in price for the year. Add in dividends and you’re up 0.1%. That isn’t likely to make equity investors feel cheerier as they’re filling their gas tanks.
The broader market is doing better, but not by much. The average domestic stock mutual fund was up 4.4% through the first three quarters, helped in large part by the continued strength this year in smaller-company shares. After last week’s market sell-off, though, the year-to-date gain on the average U.S. fund had shrunk to 1.9% by Friday, according to Morningstar Inc.
It may be hard to believe given the trend this year, but we’re entering the fourth year of this decade’s bull market.
The bear market that began in 2000, amid crashing technology stocks and shrinking corporate earnings, died Oct. 9, 2002. The S&P; 500 ended at 776.76 that day, its lowest level since 1997. The Dow Jones industrial average also reached its bear-market low that day at 7,286.27.
Why stocks turn when they do is always a great mystery, but it became clear, in retrospect, that the market was anticipating the economic expansion and corporate profit recovery that would follow in 2003 and 2004.
The first year of the new bull market saw a dramatic rebound in share prices, which is typical of the initial phase. The S&P; 500 soared 33.7% between Oct. 9, 2002, and Oct. 9, 2003.
The second year was less generous, but still decent. The S&P; rose 8% in that period and 9.9% with dividends.
The third year, measured through Friday, saw a 6.6% price gain and an 8.5% return with dividends.
So measured from anniversary to anniversary, the stock bull market still is producing returns that are superior to what you would have earned in cash accounts or in most bonds. And isn’t that why most people stay in the equity market?
It’s possible, of course, that we’re already in a new bear market and just don’t know it. The S&P; 500 hit a four-year high of 1,245.04 on Aug. 3. It’s down 3.9% since then.
The technology-dominated Nasdaq composite index is down 5.8% from its four-year high reached Aug. 2. The small-stock Russell 2,000, which hit a record high Aug. 2, is down 6.4%.
Thus far, all of these declines qualify as nothing more than very minor “corrections” within a bull phase. Historically, however, bull runs often encounter serious obstacles after three or four years.
If you knew that a new bear market had begun, and that the major indexes would fall at least 20% in the next year or so, you might want to lighten up your stock portfolio. At a minimum, you wouldn’t want to invest more in the near term.
What’s making many investors nervous is that there has been much more talk lately about the things that have traditionally been bull market killers: slowing corporate earnings growth, rising inflation and rising interest rates.
Those issues have been dogging the stock market all year and were the primary reasons that expectations for share price appreciation in 2005 were limited to begin with.
But in the last few weeks, the worries have deepened. The surge in oil and natural gas prices after Hurricane Katrina hit the Gulf Coast, knocking much of the region’s energy production out of commission, has raised fears about a debilitating effect on consumer spending, and on corporate earnings, from fuel costs.
Even as oil prices fell last week -- to $61.84 a barrel by Friday, down $4.40 for the week -- the stock market didn’t seem to think that was a significant enough pullback. The S&P; 500 sank 2.7% for the five days, its worst week since April.
Stock stabilized Friday after the government said the nation lost a net 35,000 jobs last month, a far smaller number than had been expected given the economic devastation in the Gulf Coast region.
But resilience may be the economy’s own worst enemy now, and likewise for stock and bond markets.
Why? The Federal Reserve is seriously worried about the potential for rising inflation because of energy prices. The chorus of Fed officials warning about the perils of inflation has only grown louder in recent weeks.
Dallas Fed Bank President Richard Fisher last week said in a speech that inflation was moving toward “the upper end of the Fed’s tolerance zone.” The consumer price index rose at a 3.9% annualized rate in the first eight months of the year. The core inflation rate, excluding food and energy, rose at a 2% rate.
Fisher declared that the central bank wouldn’t allow an “inflation virus” to infect the U.S. economy. Many of his peers at the Fed have made the same point in recent weeks.
The implication is clear: The Fed expects to continue raising short-term interest rates, which already are at four-year highs. And the stronger the economy seems, the bolder the Fed could become with rates.
Earlier this year, much of Wall Street expected the Fed to stop when its key rate reached 4%. The market was encouraged when Fisher, in a comment he now surely regrets, said in June that the Fed was in the “eighth inning” of its credit-tightening cycle.
Or maybe his idea of good baseball is extraordinarily long innings. The Fed’s key rate was 3% when Fisher spoke in June. It’s now 3.75%, and many economists believe it’s going to 4.5%, at a minimum -- and higher if inflation data in coming months look horrendous.
Therein is the threat to the stock market: The more worried the Fed is about inflation, the greater the chance that policymakers could overshoot, boosting rates higher than the economy can bear and raising the risk of triggering a recession.
For now, it’s probably safe to say that most investors don’t believe the recession threat is severe. If they did, stock prices would be a lot lower already.
The optimistic case that the first bull market of the 21st century still is intact, as it enters its fourth year, is built in part on stock valuations: The S&P; 500 index is priced at about 16 times this year’s estimated operating earnings per share. That seems reasonable to many veteran investors.
Indeed, average stock valuations have come down this year as corporate earnings overall have continued to rise, while stock prices have barely budged. Market bulls say stocks are too appealing to let go, even if returns are dwindling.
The Fed might just get it right with rates this time, lifting them enough to damp inflation without sending the economy into recession. But the risk of a misstep is growing, which at least partly explains why the stock market fell so hard last week.
Bill Hornbarger, a fixed-income analyst at brokerage A.G. Edwards in St. Louis, notes that whenever the Fed is tightening credit, “Their history is that someone goes through the windshield” -- meaning that rising rates always cause some kind of major financial or economic accident, which then causes the Fed to stop.
The question for equity investors is whether they’ll wind up the primary accident victims this time around.
Tom Petruno can be reached at tom.petruno@latimes.com. To read recent columns on the Web, visit latimes.com/petruno.
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More to go?
The U.S. stock bull market enters its fourth year Monday. Here are the gains in key indexes in each of the first three years.
Dow industrials
Year 1: 36.1%
Year 2: 6.1%
Year 3: 4.7%
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S&P; 500
Year 1: 36.2%
Year 2: 9.9%
Year 3: 8.5%
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Nasdaq composite
Year 1: 72.4%
Year 2: 1.0%
Year 3: 9.6%
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Russell 2,000
Year 1: 61.7%
Year 2: 11.7%
Year 3: 13.4%
Data are 12-month gains measured Oct. 9, 2002 to Oct. 9, 2003, Oct. 9, 2003 to Oct. 8, 2004 and Oct. 8, 2004 through Friday. Returns include dividend income.
Source: Bloomberg News
