Corporate profits have rebounded handsomely this year, with the typical Standard & Poor’s 500 company reporting earnings gains exceeding 20% for the first half. Why, then, is the stock market in the doldrums? From Dec. 31 through July 27, the S&P 500 was down about 2%, while the Dow Jones Industrial Average was off 4% and the Nasdaq Composite was down 7.6%.
With the stock market, the obvious analysis is often the best, says Wharton finance professor Andrew Metrick, noting that summer doldrums are not uncommon. “The stock market has built into it some expectations of what news is going to look like over the next month or two. When the market does poorly, that’s just saying that the news that came out today wasn’t as good as people had hoped.”
Wharton finance professor Jeremy Siegel calls it “‘the curse of the second derivative.’ That is: earnings are rising, but they are not rising as fast as they were before. That’s worrying Wall Street.” A case in point – Microsoft, which reported 81% earnings growth in its second quarter, only to see the share price fall because analysts had expected even more. Many investors focused on Microsoft’s caution that future gains probably will not be as big.
Stocks rose strongly in 2003 in anticipation of improved earnings, so this year’s good earnings news is already reflected in stock prices, according to Wharton finance professor Marshall E. Blume. “What will move the market is if earnings grow at a faster rate in the future than anticipated, and they’re not doing that,” he says.
Siegel, Blume and other Wharton finance professors, as well as other analysts, point to a range of investor concerns that have kept major stock indexes trading within a narrow band, with less day-to-day volatility than usual. Much of the news is mixed, neither bad enough to drive stocks down nor good enough to propel them up. Investors obviously are worried about the war in Iraq and the potential for another large terrorist attack, Siegel says, though he believes investors are becoming accustomed to thinking of terrorist threats as a constant.
In mid-July, the government released good news on core inflation, which was running at a low 1.9% annual rate. That encouraged many bond investors to believe that interest rate hikes will continue to come from the Federal Reserve, but at a slow pace the markets can absorb comfortably. “The bond market got downright giddy after the release of the June CPI and drove rates down to levels not seen since mid-April,” wrote David Joy, capital markets strategist for American Express Financial Advisors. “The 10-year Treasury note yield ended the week lower by 11 basis points, at 4.35.” Interest rates remain low by historical standards, he said.
Still, there are causes for concern in the Treasury market. Wharton finance professor Franklin Allen worries that foreign investors, including the governments of Japan and China, now own approximately half of the outstanding U.S. treasury securities. They buy them to keep the dollar strong, making Japanese and Chinese products cheap for American consumers and corporations to buy.
If these foreign investors become convinced the dollar will fall, they may dump Treasuries on the market, causing bond prices to plummet, and interest rates, which move the opposite way, to rise. A jump in interest rates would be bad for the U.S. economy and stock market. “There’s a lot of uncertainty [among U.S. investors] about what is happening in Asia,” Allen says.
Virtually all market watchers expect the Fed to continue raising rates to head off inflation. Higher rates increase corporate borrowing costs and help draw investors from stocks to bonds, often undermining stock prices.
Though inflation is low this summer, Siegel says high prices for oil and other commodities signal an inflation threat. “Oil is still very high. West Texas [crude] closed at $41.70 on Friday [July 23]. That’s a very high price …There’s concern about whether inflation can flare up.” Many people feel the strain of paying nearly $2 a gallon for gasoline, especially in summer when driving is heavy, he adds. A spike in this very visible expense can make people cut back other spending, undermining the economy’s recovery.
Job growth rebounded early in the year, with more than 300,000 jobs created in March, and again in April. But May’s figure was just over 200,000 and June’s slightly over 100,000. “Does this trend signal a slowdown?” asked Baker French, chief investment strategist for Brinker Capital, an investment consulting firm in King of Prussia, Pa. “One estimate I’ve seen said that job growth has to be at a minimum of 150,000-200,000 net new jobs per month in order to maintain the current levels of growth in the economy. If the June jobs number becomes the norm, we may be in for a period of slower growth.”
Car sales were very weak in June and retail sales appear to be poor in July, Siegel points out. “There’s a soft spot in the economy, definitely.” Nonetheless, he says he agrees with Federal Reserve Chairman Alan Greenspan, who has recently argued that the economy, despite some setbacks, will grow well in the second half.
With the polls showing President Bush and Senator John Kerry even in the presidential campaign, investors cannot place bets with a view to future economic policy. “I think Bush’s slip in the polls has been somewhat of a negative for the market,” Siegel suggests. “The stock market likes Bush because of his cuts in the capital gains and dividends taxes. And Kerry is out to reverse that – at least reverse it for people above a certain level. That is not stock-market friendly.”
Siegel, who expects Kerry to win by a narrow margin, notes that stocks have often done very well under Democratic presidents. If Kerry appears likely to win, adds Blume, investors may react negatively to the possibility of tax increases. “But on the other hand, there’s a good possibility that you would have a divided government, and nothing gets done during a divided government. So [a Kerry win] might not be that negative for the stock market.”
According to Siegel, stocks’ poor performance this year has a silver lining: With earnings up and prices down, the price-to-earnings ratio for the S&P 500 has fallen to about 17, based on projected earnings for 2004. In recent years, the ratio has often been in well above 20 and sometimes above 30. The higher the number, the greater the risk.
Over long periods, the P/E ratio has averaged about 15, though a figure in the low 20s should be considered the norm today, largely because interest rates and inflation are low, Siegel says. Hence, stocks may be slightly under-priced today. By historical standards, they certainly cannot be considered especially risky. “In a way,” he adds, “the market is more attractive now than it was three or four months ago.”
