American equity markets have bounced back after the summer slump, with the Dow Jones index hitting a succession of record highs as fears of an economic slowdown begin to fade.
Dow Jones watchers broke open the Champagne again and again as the index hit a series of new highs in the past three months, finally topping 12,000. A chorus of media pundits cheered it on, along with the broader S&P index, which is still short of its 2000 high of 1527.46. The Nasdaq, despite recent gains, remains at about half the level of its glory days.
“Since the summer, the markets have been highly data dependent,” says Charles Rotblut, senior market analyst at Zacks.com in Chicago.
The first catalyst after the summer doldrums came on August 8, when the Federal Reserve paused in its sequence of 17 interest rate hikes since mid-2004. Next, the markets danced between fears of inflationary tightening and a recessionary slowdown, according to the news of the day. Meanwhile, the rate of increase in the money supply has been rising. “More liquidity is good for asset prices,” promises Sasha Kostadinov, portfolio manager at Cleveland-based Shaker Investments.
Both business and consumer confidence have stayed robust, signaling health for the economy and dispelling anxieties over a slowdown. The reading for the Conference Board Consumer Confidence survey has remained over 100 during the entire period, with the University of Michigan Sentiment index at about 90. “The most relentless signs of well-being are the capacity utilisation number, which has stayed above its threshold, and positive manufacturing reports from the Institute for Supply Management,” notes Rob Goodman, partner of Fairport Asset Management in Ohio.
On the other hand, the housing market continues to teeter. On November 17, the Commerce Department reported that housing starts plunged in October to a six-year low, down 11.1% versus the first 10 months of 2005. “People got into mortgages beyond their means. On top of that, they face rising property taxes,” Rotblut says. “Because of the emotional value attached to a home, sellers still have not cut prices sufficiently. It could get worse before it gets better.”
On the brighter side, low levels of total unemployment and higher wages have hitherto acted as offsets.
Equity markets have taken encouragement from a new surge in mergers and acquisitions activity. Private groups have proposed to buy Four Seasons Hotels and OSI Restaurant Partners; Abbott Laboratories will purchase Kos Pharmaceuticals; Google is taking over YouTube; and the Chicago Board of Trade commodity exchange will join forces with the Chicago Merc. As an additional support for the markets, a plethora of stock buybacks has been reducing the number of available shares. And the Initial Public Offering arena has been quiet, which affords less competition for stock buyers.
Earnings have been the other crucial driver. In early 2006, original estimates predicted a growth range of 6-8% for the year. In a welcome surprise, profits have beaten that forecast, coming in twice as high. Remember, though, that this quarter’s results are being measured against the poor “Katrina” quarter of 2005. Ford Motor reported its largest quarterly loss since 1992, while Exxon Mobil almost topped its own record for the most ever earned by a public company.
Among specific sectors, technology has performed well. “Thanks to strong corporate profits and good cashflow, the capital replacement cycle is ongoing,” comments Dan Genter, president of RNC Genter Capital Management in Los Angeles.
Transparency has improved in the sector, too, as companies have moved towards fuller disclosure by expensing stock options on their balance sheets. Several high-profile chief executive officers have been charged with the shady practice of options backdating. “Companies are giving more conservative guidance these days. Stocks do better when people believe the earnings stories,” Goodman says.
As oil sold off, consumer discretionary spending rocketed. John Norris, chief economist at Morgan Asset Management in Birmingham, Alabama, attributes the move to several factors: the decline in the gasoline price, strong labour markets and slightly higher-than-anticipated hourly wage rates. Fuel-dependent transport firms have flourished too. The energy sector, meanwhile, may have seen its heyday, as comparisons with last year become more difficult and hedge funds exit en masse. Genter predicts: “The third quarter was the last hurrah for the integrated oils. But servicers and drillers should hold up if oil stays north of $50 per barrel.”
Financial companies benefit as rates stabilise. Margins are improving, despite the stubbornly persistent flat yield curve. Investment banking firms have profited from the new flurry of M&A, while insurance companies have enjoyed a lack of hurricanes.
Healthcare is one area under assault, largely because of the congressional elections in November. With the Democrats in charge of both houses, investors fret that the government may try to negotiate prices for the purchase of drugs with the major pharmaceuticals. Yet the Democrats’ victory, which encompasses support for stem cell research, has already energised the biotech sector.
On the whole, the election may turn out “not to be a big deal”, according to Rotblut. The president is likely to veto Democrat proposals. Besides, the balance of power is so close in the Senate that it will only take a few people to “jump aisle” to prevent new legislation from passing. Historically, US markets generally perform better with split leadership, which hinders lawmaking and maintains the status quo.
Auguries for the next few months look promising. Seasonal patterns are typically strong between November and March, with the pre-election year cycle adding some additional oomph. Norris notes that his clients are finally shaking off some of their lingering hangovers from the bear market, after witnessing four consecutive decent years.
Inflation could still prove the fly in the ointment. The October Federal Open Market Committee meeting reported that nearly all participants regarded the current rates of core inflation, running between 2.4% and 2.9%, as “uncomfortably high”. Still, if interest rates hold steady or decline, we may even see some expansions of price/earnings multiples. As the yield on treasuries declines, stocks will be able to compete better with bonds. The S&P’s current multiple, at 17, has fallen from 26 in October 2002. “Even if we have to digest an overall slowing economy, there is no reason for further contractions,” Genter says.