Declare Your Financial Independence

Following conventional market wisdom has been a sucker's game this year. So here are five tips for helping you to think for yourself

By Amey Stone

Just plain wrong. That's the best way to describe Wall Street's stock market prognostications so far this year. First the smart money thought equities would continue last year's rally with strong gains throughout the first half of 2004. Instead we got a whole lot of nuthin' -- thin trading and year-to-date market averages essentially unchanged.

More recently, the collective wisdom had it that the after June 30 -- when the transition in power in Iraq was scheduled (it took place two days earlier) and the Fed was expected to raise interest rates (which it did by a quarter-point) -- investors would be relieved, and stocks would rally. Wrong again. They tanked on July 1. The Dow Jones ended the day off 101 points, to close at 10,334, and the Nasdaq fell 32 points, to 2,016, on mounting evidence that the economy and corporate profits may have cooled a bit in June.

The fact that Wall Street wisdom has been all wet makes this Independence Day a good time for investors to do some independent thinking. Also, it's always good to reassess your portfolio halfway through the year. The following are five major trends to ponder while flipping burgers this holiday weekend:

1. Interest rate hikes have just begun.

The Federal Open Market Committee's decision to raise short-term rates from 1% to 1.25% is likely the first of many to come. The Fed is expected to tighten several more times over the next 18 months.

These moves will create a headwind for stocks, especially financials. The bull market of the '80s and '90s was driven by 20 years of declines in interest rates, says Trip Jones, managing director of sales at SunGard Institutional Brokerage. "That baby is over," he says. Uncertainty about how stocks will react to rising rates is a major reason investors have been staying on the sidelines lately.

Higher interest rates will also weigh on U.S. consumers, who are shouldering more debt than at any other time in history and will soon face higher credit-card and mortgage bills (see BW Online, 7/01/04, "Can Consumers Cope With Higher Rates?").

2. Signs of a housing market bubble are popping up.

Home prices have been rising at an unsustainable pace for the past five years, driven mainly by low interest rates that made mortgage payments affordable. But even though mortgage rates started rising a year ago, the housing market saw sales hit record levels in May. It's likely that this is the last flurry of activity before housing finally cools.

"Home-buying activity might finally be in the process of forming a long-awaited peak," concluded John Lonski, chief economist with Moody's Investors Service, in a recent research note concerning the slight drop-off in mortgage applications in June.

3. Corporate profits are booming.

For the past four quarters, U.S. companies have seen surging earnings growth, widening profit margins, and a big jump in positive earnings surprises. And, since the stock market has been flat, the forward price-earnings ratio on the Standard & Poors has fallen to 17 -- its average over the past 20 years, says Lincoln Anderson, chief investment officer at LPL Financial Services.

So why haven't stocks risen? "I believe that short-term concerns about interest rates, inflation, oil prices, and Iraq have distracted investors from appreciating the amazing rebound in profits and cash flow," Edward Yardeni, strategist with Prudential Equity Group, wrote in a June 22 report.

Anderson believes strong corporate earnings will eventually trump all the worries. "Investors should stay focused on the big picture," he says. "We've got really strong earnings, a return of pricing power, and strong productivity growth." And the second-quarter earnings season kicks off in mid-July.

4. Cowboys are dominating the markets.

Stocks could be extra volatile the rest of the year as individuals stay on the sidelines and program trading grows. Since late May, trading volume has been much lower than normal -- even for this time of year (see BW Online, 6/23/04, "No Stocks, Please, We're Skittish"). Program trading (in which large investors, often hedge funds, buy and sell baskets of stocks), now makes up about half of all trading volume on the New York Stock Exchange.

"It used to be more like 11%," says Ned Riley, chief investment strategist at State Street Global Advisors. He says hedge funds -- unregulated pools of investment funds designated for high-net-worth individuals -- now have undue influence on the markets. "This group not only has the flexibility of acting in a very short time frame but can also use substantial leverage," he says. The result: Long-term investors, both individuals and institutions, better get used to getting whipsawed.

5. The first wave of baby boomers is reaching retirement age.

And how many of them have saved enough to stop working? Individuals' 401(k) plans haven't been cooperating. And not only does the solvency of the nation's Social Security system create concern but corporations are struggling now to come up with adequate reserves to fund their own pension plans. The national savings rate is just over 2%. That's "extremely low" considering boomers should be at their peak savings years, says Dean Baker, co-director of the Center for Economic & Policy Research.

The aging of the baby boomers is a sleeper issue that will eventually put greater stress on the country's health-care and retirement-benefit systems. It's likely to have ramifications for the broader economy, including the stock market and housing market, that can't yet be foreseen.

But you can be sure Wall Street prognosticators will have opinions about all these and other issues affecting the stock market. And they may not be any more accurate than they've been so far this year. That's why investors might want to free themselves from conventional thinking this Fourth of July.

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

Edited by Patricia O'Connell

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