Happy end to 4Q in doubt

Higher rates, Rita, Katrina may hurt usual robust finale

October 04, 2005|By THE DALLAS MORNING NEWS .

Stocks will have to put on quite a show in the fourth quarter to match last year's returns, or even many analysts' current forecasts.

Last year at this time, stocks were in about the same position as now - flat to down for the year. The market rallied after the presidential election and pushed the Standard & Poor's 500 index to a 9 percent gain for the year.

This year, fallout from hurricanes and interest-rate increases may stand in the way of such a happy ending.

The good news for investors is that history is on their side. If the market can escape the treacherous waters of October unscathed, the fourth quarter, on average, delivers more than any other three-month period.

Optimists say stocks so far seem to have passed the test of Federal Reserve rate increases in the midst of an enormously disruptive hurricane season.

"One of the best ways to test a market's mettle is to see how it behaves in the face of adversity," said Alfred E. Goldman, chief market strategist at A.G. Edwards & Sons Inc. in St. Louis. "We've just come through a whole month of tremendous adversity, and stocks have bent but not broken."

Goldman predicts stocks will tack on about 7 percent before the year end.

Entering the final stretch, the Dow Jones industrial average is down 2 percent for 2005, and the technology-heavy Nasdaq is off 1.1 percent. The broad S&P 500, however, has put up a gain of 1.4 percent.

Two weeks ago, stocks suffered their worst week of the third quarter as another hurricane bore down on Houston, the nation's energy capital. But last week, despite so-so economic news and skyrocketing energy prices, stocks bounced back with gains of more than 1 percent.

Tobias M. Levkovich, chief market strategist at Smith Barney in New York, said the hurricanes actually might have done investors a favor.

Some of the earnings disappointments that might have surfaced in October were accelerated by the storms - and Wall Street will understand problems from a one-time event such as Katrina, he said.

"Of course, if they're still talking about this in November, then you've got a problem," he said.

Overall estimates for the S&P 500 companies have actually risen since Aug. 26, the Friday that preceded Hurricane Katrina. Earnings are now expected to grow by 17.9 percent, up from 16.1 percent, according to Thomson Financial, which tracks earnings estimates.

The explanation is in the details: Energy companies' earnings are expected to soar 72 percent, up from a forecast of 44 percent before the storm.

Excluding energy companies, third-quarter earnings are now expected to rise by 11.4 percent, down from 12.8 percent.

Those with the worst earnings prospects tend to be those affected by increased energy costs, such as materials companies and the manufacturers of discretionary consumer goods.

But Thomson research analyst David Dropsey warned: "A lot of analysts still don't know what to expect."

Some skeptics say it's hard to be too bullish about the market's prospects when you add the uncertainty of the third-quarter earnings season to the other big unknown - the Federal Reserve.

The central bank has two more opportunities to tighten credit this year, and the financial markets expect it to happen both times.

Since its campaign began more than a year ago, the Fed has tacked 2.75 percentage points onto its federal funds rate, which now stands at 3.75 percent.

As of Friday, the federal funds futures market was pricing in about a 90 percent chance of an increase in November, a 70 percent chance in December and an even chance that another will follow in January. This accumulation would bring the federal funds rate to a level most economists call "neutral," just in time for Fed Chairman Alan Greenspan to retire.

"If neutral is between 4 and 5 percent and we raise at the next three meetings, Greenspan goes out at 4 1/2 percent on the fed funds," said Steven Wood, chief economist at Insight Economics in Danville, Calif. "This way, whoever succeeds him inherits a neutral rate."

Long-term investors would be well-positioned, experts say, if Greenspan's successor has enough flexibility with monetary policy to fight an economic downturn.

In the short term, though, those higher interest rates tighten the vise on a housing sector that is showing signs of weakening.

The stakes for all Americans - homeowners or not - are high: Housing has contributed nearly half the country's jobs and economic growth since 2001.

"Housing has been a huge growth engine for this economy, and that's another reason rates really matter," said Francois Trahan, chief investment strategist at Bear Stearns in New York.

Throw in rising energy prices and the effect of higher interest rates on credit card bills, and the American consumer is looking pinched, too.

Moreover, employers have already proved in this current four-year recovery that they have no problem reining in hiring plans or accelerating layoffs at the slightest whiff of a slowdown in the economy.

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