Winds of Uncertainty Hit the Markets

Major stock market indices lose ground
Higher interest rates, rising energy costs, and continued unrest in Iraq helped to push stock prices lower in July. The Dow Jones Industrial Average* lost 2.8 percent to close the month at 10,140. In the broader market, the S&P 500 declined 3.4 percent to close at 1,102, and the Nasdaq Composite Index finished the month at 1,887—down 7.8 percent. The 2.8-percent decline in the Dow's blue-chip stocks marked this index's largest monthly drop since January of last year, while the Nasdaq experienced its largest monthly decline since December 2002.

Key factors driving this downward trend appear to be rising energy costs and broad-based selling among hedge fund managers, who began retooling their portfolios in response to the Federal Reserve's (the Fed) decision to lift interest rates at its June 30 policy meeting. Although hedge funds represent a relatively small portion of the overall market, their collective moves can often lead to heightened volatility and short-term market swings, particularly in the summer months when trading volume is generally light.

Despite the current weakness in the market, the fundamentals, which drive longer-term results, remain positive. At 19 times forward-looking earnings, the price/earnings ratio of the S&P 500 appears undervalued given current interest rate levels and the strength of corporate earnings to date. Although final statistics for the second quarter have yet to be tallied, 80 percent of S&P 500 stocks have reported second quarter results, with an average year-over-year increase of 27 percent.

And while interest rates will likely continue to advance in coming months, Fed Chairman Alan Greenspan has gone to considerable lengths to reassure both Wall Street and Main Street of his intent to raise rates at a “measured” pace. In current Wall Street terms, this means a series of quarter-point moves.

Record-high oil prices raise concerns for economy, inflation, corporate profits
Perhaps of greater concern for the markets and the economy today is the extent to which energy costs—specifically, oil prices—have jumped in recent weeks. The price of oil rose to a record $42.82 a barrel in July (and closed above $44 a barrel in the opening days of August). Concern over production capacity at OPEC, rising demand from China, continued violence in Iraq, and a threat to output at Yukos, the second-largest oil producer in Russia, were major factors contributing to the increase. Yukos, which is responsible for 20 percent of Russia's oil output, was recently ordered to pay $3.4 billion for an accounting discrepancy in 2000, elevating concern that the firm might be forced to stall production. Renewed threats of terrorist attacks, storms in the key oil- and natural gas-producing region in the Gulf of Mexico, and an oil workers strike in Norway also played roles in the July increase.

The price of oil has far-reaching implications for the global economy, as well as for the pace of U.S. expansion and inflationary pressures going forward. Rising energy costs have already led to a mild increase in inflation. The Consumer Price Index (CPI) is ahead 3.3 percent in the past year. Core inflation, which excludes the more volatile food and energy components, rose 1.9 percent in the same period. To date, manufacturers have been reluctant to raise prices for fear of losing revenue and market share. Strong productivity gains in recent years have also enabled firms to deliver solid earnings in the face of higher costs. But the sharp rise in energy prices and the longer-term impact of higher oil prices on both the domestic and global economies imply that manufacturers will soon be forced to raise prices to protect earnings, which, in turn, will result in higher inflation in the months ahead.

U.S. economic growth slows
Higher oil prices and the rise in interest rates helped cool the pace of economic activity in the most recent quarter. Gross domestic product (GDP)—the broadest measure of overall economic growth—slowed from a 4.5-percent annual growth rate in the first three months of the year to a 3-percent pace in the most recent quarter, marking the slowest quarterly advance since the opening quarter of 2003.

Consumer spending, which represents about two-thirds of GDP, played a large part in the unexpected decline. It fell from 4.1 percent in the opening quarter of 2004 to 1 percent in the most recent period. Slower-than-expected job market growth in July—with an estimated 32,000 workers added to the nation's payrolls—provided further evidence that the pace of the recovery has slowed. Economists had been expecting job growth in excess of 228,000.

But bonds rally
The Fed's decision to lift interest rates combined with the greater-than-expected slowdown in GDP to spark a surprising rally in U.S. bonds, with the yield on the benchmark Treasury falling to a three-month low of 4.35 percent in July. Conventional wisdom suggests that bonds will lose money following an interest rate increase, yet the reverse occurred.

Bond yields had been moving higher in recent months amid fear that strong economic growth in the first half of the year might spark inflation if the Fed continued to sit on its hands. The June 30 move, which marked the first interest rate hike in nearly four years, served as firm evidence of the Fed's intent to keep things in check.

The concerns ahead
Looking ahead over the next six to 12 months, there are renewed concerns over potential terrorist attacks at financial centers in the U.S., and uncertainty over the outcome of the upcoming presidential election. The geopolitical uncertainty is clearly reflected in the lower multiples that investors are willing to place on corporate profits, which are rising at a solid clip. Investors will probably again flock to Treasury securities and shun equities, as oil prices spike. The political elections set for this year have created another level of uncertainty for investors. The only two recent times that investment markets have declined in Presidential election years were 1960 and 2000. In those years, voters ousted the incumbent party from the While House.

While the housing market remains a pillar of strength for the economy, there are also concerns that an unexpected "perfect storm" of events -- such as rising rates, regulatory reform for the mortgage financing companies, and the moving of the Baby Boomers from an acquisition phase to a disposition phase -- will at some point weaken that pillar. The important statistic to watch right now is not housing starts or even interest rates. Rather, it is the supply of homes for sale that should be the focus. Currently, home inventories are at about 4.5 months, a far cry from the 9-month level that characterized the last housing decline, in the early 1990s.

The current account deficit, as well as trends in the dollar and gold, could also destabilize the U.S. economy's leading global position, if not checked over time. Corporate governance may be receding from the headlines -- the last of the bunch, Kenneth Lay of Enron, was recently led off to a hearing in handcuffs -- but the issue can crop up on a company-by-company basis (i.e., Cardinal Health, Royal Dutch Shell, Nortel Networks, Veritas Software).

Market opportunities
Hopefully, these uncertainties worrying markets are overblown and will ease in the year ahead. Meanwhile, the reaction of markets to these uncertainties has opened up some opportunities. Favored investment areas currently include industrial, financial services and healthcare stocks. Among financial service companies, earnings expectations appear low-to-reasonable over the next few quarters. Though the consensus view is that financial stocks perform poorly during periods in which the Federal Reserve raises rates, the historical evidence suggests something else. There are particular opportunities in areas such as corporate financing, investment banking and the securities and transaction processing businesses. Meanwhile, healthcare valuations are attractive, as are growth prospects among the medical devices. And industrial stocks could be poised to top expectations for a few quarters as the dollar has started to slip again and productivity growth remains high.

Three other opportunities worth mentioning are Dividend-paying stocks (the profit surge in the last year means companies have the extra cash flow); International stocks (political and economic forces may drive the dollar down further over the next few years which would tend to amplify the return on international stocks for the simple reason that they are denominated in foreign currency); and, Flexible asset allocation investing (following the big backup in interest rates this spring, bond yields seem to be close to fair value while surging profits could make stocks look somewhat cheap; there is thus an advantage to being able to quickly move between these two major asset classes).

Concluding advice
Entering the second half of 2004, the economy looks healthier but is still vulnerable to attacks from abroad or policy missteps at home. Because of this, investors need to be diversified. However, it is also important that we recognize one of the biggest risks always facing individual investors: the risk of our own good health. On average, individuals celebrating our 65th birthday today have just over a 5% chance of making it to our hundredth year - and if we don't get our money to grow, we won't get our money to last. Because of this, it is more important than ever that we position long-term money in a diversified portfolio of long-term assets.

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