Hail to the Bull vs. Tail of the Bull


By Amey Stone Nothing beats a triple-digit one-day gain in the stock market to get bulls snorting with pleasure again. The last week of March brought a combination of more subdued economic growth (fourth-quarter gross domestic product came in at 3.8%, when 4% growth was expected) and a drop in oil prices, which made investors less concerned about the threat of higher inflation. That news, combined with the Federal Reserve's Mar. 22 promise to renew its inflation-fighting vigilance and some end-of-quarter window-dressing on Wall Street, ignited a major stock market rally on Mar. 30, when the benchmark Dow Jones industrial average rose 135 points, or 1.3%.

Indeed, the three major indexes turned in the biggest one-day percentage gains so far in 2005. Then Mar. 31 brought light selling as oil prices climbed, and some traders took profits. The Dow closed at 10,503, down 37 points.

INFLATION-FIGHTING FED. But overall, bullish strategists were feeling more confident. They expect the Labor Dept.'s employment report due Apr. 1 to show payroll growth of around 225,000 for the month of March -- and more proof of a not-too-hot, not-too-cold economy to emerge (see BW Online, 3/30/05, "Jobs: Solid, Not Spectacular"). Furthermore, bulls look to the start of first-quarter earnings season, just around the corner, to get investors focused on strong corporate profits, instead of macroeconomic worries.

"Too many strategists have been screaming about this fear of rising rates," says Trip Jones, managing director of sales at SunGard Institutional Brokerage. His bullish case for stocks rests on low valuations (the forward price-earnings ratio of the S&P 500-stock index dipped below 16 just before the Mar. 30 rally), a healthy consumer, and scant signs that inflation will become a problem. He believes the market is still riding the uptrend that began in October, 2004 -- although he admits his thesis has been tested in the first quarter of 2005.

The bullish scenario may not yet be unshakable, however. Even as many strategists express relief that the Fed has focused on inflation-fighting, a growing chorus is worrying that Greenspan & Co. may overdo it. By concentrating on inflation, the Fed risks raising short-term interest rates too much and stamping out economic growth, some believe.

WHAT "TIPPING POINT"? Jeffrey Knight, chief investment officer for Putnam Investments' global asset-allocation group, believes record levels of consumer debt have made the economy much more sensitive to higher interest rates. Therefore, he thinks the Fed should avoid lifting short-term rates above 3.5% -- the federal funds rate is now at 2.75% -- for fear of risking a recession. Many observers believe a neutral Fed funds rate would be 4.5%.

If rates move beyond an unknown "tipping point," where consumers clamp down on spending, "it could very quickly and precipitously change the momentum of the economy," Knight says.

Michael Panzner, head trader at Rabo Securities, sees the economy and corporate earnings more gradually "running out of steam" in the coming year due to steeper oil prices, higher interest rates, the rising cost of debt service for consumers, and Corporate America's squeezed profit margins. "Any one straw doesn't say 'recession,'" according to Panzner, "but put all those things on the economy's back, and there's a real potential for a slowdown."

"QUARTERS OF HEADACHES." On Mar. 28, Barry Ritholtz, chief market strategist at Maxim Group, issued a bold call to his clients in a research note, "The Trap Is Set: Last Chance to Reposition." His forecast: The market is set to rally from oversold conditions -- but investors should treat any gains as an opportunity to sell. He expects stocks to rise for another week or two, but not on a great deal of volume or cash inflows.

After that, Ritholtz sees the market giving back those gains as higher oil prices and interest rates come home to roost. He thinks the Dow could fall between 10% and 15% by this summer. "We're due for a couple of quarters of headaches," he says.

For investors just starting to regain confidence in the bullish case for stocks (now that inflation fears seem to be receding), such negative forecasts sound like calls for rain on a parade. But with rising energy prices and interest rates both in the forecast, investors should pack their proverbial umbrellas when investing this spring. Stone is a senior writer for BusinessWeek Online in New York


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