What's Spooking the Street

Corporate earnings are up, oil prices down, and economic indicators healthy. Yet investors remain nervous -- and for good reasons

By Amey Stone

The market has been waffling all year due to familiar worries -- spiking oil prices, rising interest rates, and less-than-stellar corporate earnings growth. Finally, the past few weeks have brought encouraging news on all those fronts. Oil prices have fallen to $48 a barrel from early April's spike to $58. The 10-year Treasury yield slipped to 4.12%, the lowest level since February, and corporate earnings for the first quarter came in stronger than expected -- 16% higher than a year ago, according to BusinessWeek's corporate scoreboard.

Yet, just when it seems stocks might be poised to rally, a new crop of risks -- rumors of imploding hedge funds, alarmed bond investors, political sparring over nuclear weaponry, even a domestic terrorism scare from an errant plane over Washington, D.C. -- has rattled traders. The Dow Jones industrial average fell 205 points, or 2%, in the week ended May 13, to close at 10,140. For the year the index is down 6%.

Many strategists expect more uneasiness in the coming weeks, as the prospect of further Federal Reserve rate hikes in the face of slowing consumer and corporate spending provides an unappetizing backdrop for buying stocks. "There are a number of potential blow-ups out there," says Barry Ritholtz, chief market strategist at Maxim Group. "When you look at risk vs. reward, it is just not an advantageous ratio right now."


  The most serious of the new risks rattling investors is that hedge funds, derivatives, and debt could prove a combustible mixture for the global financial system. In the second week of May, rumors surfaced that some big hedge funds were tanking as complex trades based on the securities of General Motors (GM ) and Ford (F ) went awry. As the implosion of hedge fund Long Term Capital in 1998 showed, the demise of a major player in that lightly regulated, highly leveraged investment arena can lead to significant losses at the global banks that lend them money.

"Borrowing has a tendency to make mistakes very expensive," says Peter Cohan, an author and investment strategist in Marlborough, Mass. "Today there is more leverage in hedge funds and a similar lack of information about what they are doing." If a problem is intensifying, "We won't know until it is too late."

Ripples from the downgrades of GM and Ford's debt have rocked the corporate bond markets, and investors have fled to the safety of U.S. Treasurys. Currency markets seem newly wobbly as China makes some noises about revaluing its currency. Meanwhile, 2003-style worries about nuclear proliferation, domestic terrorism, and the future of Iraq have vexed traders.


  "Many people have gone broke forecasting Armageddon, but there seems to be an increased possibility of a financial accident," says Michael Panzner, head trader at Rabo Securities and author of the book, The New Laws of the Stock Market Jungle.

Economic news is ambiguous at best, and investors are trading day-to-day based on conflicting reports. For example, on May 12, the government's retail sales figures for April were much stronger than expected, but that same day, Wal-Mart (WMT ) warned it was falling short of second-quarter goals. In a recent report, Arnie Berman, technology strategist at CreditSights called the economic picture, "an unappetizing mishmash."

Investors wouldn't be so jittery if they weren't worried about the major underlying risk for stocks: That the Fed will overshoot and keep raising rates as the economy cools, observes Panzner. "When the market is as vulnerable as it is now, it creates potential for a spooking," he says.


  Ominously, Nicholas Bohnsack, an investment strategist with International Strategy & Investment in New York, notes that all too often a Fed tightening cycle has ended with a financial crisis. He doesn't think we've seen that crisis yet -- just the signs of how one might eventually develop.

Many strategists expect stocks to bottom in the summer after a more serious shake-out, and they are ready to buy at lower prices when they do. "I am not only looking for cheaper stocks -- I want to see a badly oversold market," Ritholtz wrote in a May 13 note. "Ideally, the market will overshoot to the downside, creating bargains."

Bohnsack says a sign from the Fed that its tightening cycle is over will be his cue to start buying stocks. "That will alleviate a lot of other overhangs and the market can move higher from there," he says. His firm has a 1,325 yearend target for the S&P 500, which is 14% higher than its current price of 1,154.


  But the end of interest-rate tightening seems nowhere in sight. April's job report showed robust growth in payrolls, giving the Fed ammunition to raise short-term rates if inflation pressures continue to worsen. Upcoming reports on producer prices (May 17) and consumer prices (May 18) could be bad news for stocks if they provide evidence of rising prices.

Many individual investors, with portfolios still under water from five years ago, are staying on the sidelines, leaving lots off room for skittish institutional investors to react to news, generating major volatility, notes Cohan. The year may end on an upswing, but for those riding this year's roller coaster, the stomach-churning thrills and chills are far from over.

Stone is a senior writer for BusinessWeek Online in New York

Edited by Beth Belton

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