A Bad August. A Worse September?


By Amey Stone September is historically the worst month for stocks, but it seems to have arrived early this year. Stocks soared in July as companies posted surprisingly strong second-quarter earnings. But equity prices stalled as August began, and they've stumbled ever lower as the month draws to a close. The Dow Jones industrial average fell 161 points, or 1.5%, in the week ended Aug. 26. Year-to-date, it's now down 4%.

Investors increasingly try to trade ahead of seasonal trends in the market, so it makes sense that they would sell before September starts, says Michael Panzner, head trader at Rabo Securities and author of The New Rules of the Stock Market Jungle. But that explanation goes only so far.

Panzner, like many professional investors, also sees more substantive reasons for late August weakness, including soaring energy prices, higher short-term interest rates, and potential for weaker consumer spending ahead. "It seems to be a combination of people anticipating the September season and also realizing that the economy may finally be running out of steam," he says.

"DEAD WRONG" ABOUT OIL. While no signs indicate that's happening yet, investors have reason to worry that such evidence will start showing up next month. The main concern is higher oil prices. Crude is now at $66 a barrel, and although it's likely to slip as the peak summer driving season ends, expectations are that it won't return to below $60 this year.

The economy has weathered oil at $50 quite well. But as Morgan Stanley's famously bearish chief economist Stephen Roach noted in an Aug. 15 report, just because people who thought oil at $50 would "derail the global economy have been dead wrong" is no reason to think the same is true about oil at $60 or $70.

Another reason for concern: Consumers are stretched. The personal savings rate in July was zero after years of small gains. Wal-Mart's (WMT) warning on Aug. 16 that higher oil prices could dampen sales was a shot across the bow, even though the retailing behemoth's second-quarter revenues met expectations, notes John Lonski, an economist at Moody's Investors Service.

MORE FED MOVES? Many strategists are concerned that consumer spending has been propped up this year by a bubblicious housing market, and they see signs that real estate is peaking. Existing-home sales in July slipped, and the price of the median new home dropped from prior months. Still, dollar-sales volume hit a new record.

A "frothy" housing market is one of Fed Chairman Alan Greenspan's biggest worries and is one reason the the central bank is likely to keep raising rates. "Up until last month there was a sense the Fed would be done by the end of the year," says Michael Cuggino, portfolio manager of the Permanent Portfolio fund. "Now there's a realization the Fed isn't done at 4% and may increase rates into '06." Some investors fear the Fed will hike rates too far and could throw the economy into recession (see BW Online, 8/29/05, "On Tap for the Next Fed Chief: Trouble").

All this will probably make September more worrisome than usual. The danger is that higher oil prices and rising interest rates will cause corporate executives to ratchet back spending plans. And when traders and analysts get back from their summer vacations, they'll likely start cutting their forecasts for corporate earnings growth.

BUYING OPPORTUNITY? "I always get a little worried in August," says Brent Wilsey, president of Wilsey Asset Management in San Diego, who now advises customers to have about 30% of their portfolios in cash. He thinks higher energy prices will cause businesses to be more careful than usual this September. "I have a cautious view of consumer spending and business expansion plans until energy has stabilized," he says. "No one wants to be brave."

However, Wilsey thinks energy will come down in price as people conserve more, and he expects stocks to rebound after the jitters pass. He plans to use a pullback as an opportunity to buy stocks like U.S. Steel (X) and Alcoa (AA) at a cheaper price. He's encouraged that companies are doing things like buying back stock, increasing dividends, and acquiring new divisions.

Lonski notes that no evidence shows consumers are rolling over. Business sales are growing faster than inventories, which normally signals an economy that's speeding up (he calls a recent weak durable-goods report a "fluke"). The housing market will benefit from tighter lending terms as the froth dissipates, he believes. And consumer spending will stay strong as the job market continues to improve.

A CASE FOR GROWTH. Indeed, a contrarian argument holds that investors' increasing pessimism is a sign that they should now increase their stake in stocks. Gail Dudack, chief investment strategist at Sungard Institutional Brokerage, points out that bearish sentiment is rising sharply, a reassuring sign. "All the market needs now is a positive catalyst," she wrote in an Aug. 24 report. "Could that be a retreat of oil prices?"

Cuggino doesn't believe a bad August for stocks necessarily signals that worse will come in September. "My view is that there are lots of factors that make a case for growth in equities that outweigh the negatives," he says. He suggests that investors seek companies that either have the ability to pass on price increases or are in industries that aren't as sensitive to oil prices, like entertainment, pharmaceuticals, or technology.

With equity-price declines accelerating before September has even begun, that's tough advice to follow. For now, most investors will likely wait until the current jitters pass and oil prices slip before they get back to stock-picking.

Stone is a senior writer for BusinessWeek Online in New York


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