Wall Street's World-Class Worrywarts

Despite terrific economic fundamentals, investors have been locked in a funk over war, oil, politics, and especially rising rates

By Amey Stone

Investors have been worrying all summer, and they aren't likely to stop anytime soon, even though U.S. economic fundamentals look near perfect. Growth is strong (but not too strong), inflation remains low, corporations are raking in the dough, and consumer confidence is up.

Indeed, consensus estimates for the preliminary second-quarter gross domestic product (GDP) figure, due out on July 30, are for solid 3.8% growth, although economists at research firm Action Economics are looking for 4%. Second-quarter earnings for companies in the S&P 500-stock index are averaging 24% higher than last year -- the fourth consecutive quarter of 20%-plus gains.

There's more: Corporate America is now benefiting from the largest annual increase in profits since 1984 and is enjoying "extraordinarily ample amounts of liquidity," noted Moody's Investors Service in a July 27 report, in which it estimated the broad equity market was 20% to 30% undervalued.

NO MOOD TO GAMBLE.

  So why all the worry? In a nutshell: Investors think growth has already peaked. From here, many expect earnings increases to slow, consumer spending to weaken, and housing markets to teeter as interest rates rise along with inflation. As for second-quarter GDP, "the number would have to be pretty dramatically out of line for the market to react," says Zachary Karabell, senior economic analyst at Fred Alger Management, adding, "I don't believe the market is trading on macroeconomics right now."

And how. Politics, Iraq, oil, and terrorism are all keeping investors in no mood to risk their money. Now, as peak earnings season passes and the Democratic convention winds up, Fed-watching is next up as for the market's fixation on the half-empty glass. The Fed's next rate-setting meeting is Aug. 10, and another quarter-point hike is expected.

"The reality is that you can't get away from the idea that interest rates are moving higher," says Michael Panzner, a trader at Rabo Securities and author of the upcoming book, The New Laws of the Stock Market Jungle. He believes the economy may already be slowing, not from just the reality of slightly higher interest rates but also from Greenspan & Co.'s rhetoric that it will continue to raise rates at a "measured" pace. "The Fed has made it clear interest rates are headed higher," he says. "Investors are adjusting now rather than waiting for the rate move."

THROWING IN THE TOWEL.

  Richard Hastings, retail-sector analyst at consulting firm Bernard Sands believes consumers are already feeling the pinch from rate up-creep. High oil prices and wages that aren't keeping pace with inflation haven't helped. The latest consumer confidence survey from the Conference Board, which shows that respondents view their "present situation" a bit better than their "expectations" for the future, is "an ominous warning that consumer mood is topping out," he wrote in a July 27 commentary.

A usually upbeat Edward Yardeni, strategist for Prudential Financial, seemed to throw in the towel in a July 27 report titled, "Curbing my Enthusiasm." He lowered his targets for the S&P 500 for yearend 2004 and 2005 (to 1190 and 1300, respectively), bemoaning a market that "hasn't been impressed" with all the bullish scenarios he correctly predicted (like strong earnings growth, low inflation, and the 10-year Treasury below 5%). "I am simply running out of new happy things to say," he wrote.

Panzner admits that psychology is playing a big role in the markets. Even though many market strategists believe stocks will eventually track strong economic fundamentals, they're calling for a bull market later this year rather than predict a rally now in the midst of so much uncertainty. "Should the election come and go without incident, this would set up perfectly a healthy yearend rally scenario," writes Ryan Beck, Chief Investment Officer Joseph Battipaglia in a July 23 note.

"UNDERSPENDING."

  Gail Dudack of Sungard Institutional Brokerage thinks the first Presidential debate on Sept. 30 could be when the market turns. For now, "the correction phase continues," she wrote in a July 21 research report. "It has only been five months long, but it feels like five years."

Recent malaise could even be creating a buying opportunity. "American corporations are underspending their cash flow tremendously," says Milton Ezrati, senior economist and strategist at Lord Abbett & Co., who estimates that the corporate cash hoard has grown to a half-trillion dollars. "There's tremendous room for them to expand, pay dividends, buy back shares, and do all those things that tend to boost the market."

Already, data from July is pointing toward a resumption in economic growth from June's soft spot. "I'm quite happy with the notion that July will reverse perceived weakness in June data," says Mike Englund, chief economist for Action Economics. He believes weakness in June reflected temporary noise from things like a late Memorial Day and former President Ronald Reagan's funeral.

Despite all that, investors are likely to keep wringing their hands and waiting for more data before breaking out of their funk. A preliminary look at second-quarter GDP isn't likely to do much to assuage their concerns. But for contrarian types, the report should offer a reminder that the economy is doing just swimmingly, even as stocks barely manage to tread water.

Stone is a senior writer at BusinessWeek Online and covers the markets as a Street Wise columnist

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