The Tug of War

Higher interest rates can put pressure on stock prices, but strong corporate earnings usually boost equities

By Joseph Lisanti

In his April 20 appearance before Congress, Alan Greenspan observed that "threats of deflation...are no longer an issue." Stocks promptly headed down because investors interpreted the statement as subtle assurance of an interest rate increase. The market stabilized the next day when the Fed chairman eased investors' fears by noting that inflation pressures did not appear to be building.

That deflation is no longer a worry should not come as a surprise. On the other hand, Greenspan's comments on inflation may puzzle anyone who has bought gas for the family car recently. Part of the disconnect is the way that the consumer price index is calculated. The "core" CPI excludes food and energy costs because they are deemed too volatile.

As a result, the 22% rise in the national average price of regular gasoline since the start of 2004 isn't captured in the core CPI rate. Increases in the prices of everyday purchases like gas make some individuals believe that inflation is higher than the government indicates. Whatever the belief of most investors, it is clear that the economy is growing, and the pricing of many products and services is becoming firmer. That leads us to conclude that the Fed is likely to raise short-term rates from their 46-year low, perhaps as early as June.

Right now, the market is being pulled in two directions, with bears focusing on the prospect of higher interest rates and bulls concentrating on strong corporate earnings. Standard & Poor's equity analysts believe that, when the current reporting period is over, the S&P 500 will have posted a 20% year-over-year increase in operating earnings for the first quarter of 2004. They see almost as large a gain in the second quarter.

Although higher interest rates are not a plus for equities, we think that the strong earnings picture will support stocks. We expect the S&P 500 to post a 9% advance in 2004.

Lisanti is editor of Standard & Poor's weekly investing newsletter, The Outlook

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