It's Spring. Beware of the Bears

Rising oil prices, a soaring trade deficit, and the weak dollar are making stock strategists extra-cautious about the near term

By Amey Stone

Think of it as sludge on the wheels of the economy. Crude oil hit a record price of $57.60 a barrel on Mar. 17 and closed at $56.72 the next day. Prices at this level will translate into increased costs for both consumers and businesses, and contribute to slower economic growth in the months to come. Small wonder the markets have been sluggish of late, too. Since the S&P 500-stock index reached 1225 on Mar. 7, the benchmark index has fallen 2.8%, to 1189.

But oil isn't the only worry investors face. In the past few weeks, even as crude hit record levels, bond yields also rose sharply. The 10-year Treasury is now trading around 4.5%, when only a month earlier it was 4%. Higher inflation and climbing interest rates are two surefire bull-market slayers. Plus, even with the equities essentially flat so far this year, stocks aren't cheap. Market averages have climbed 50% in the past two years, leaving fewer clear bargains on the table.


  "Put it together, and it's hard to get real bullish this year on U.S. stocks," says Jeffrey Knight, chief investment officer for Putnam Investment's global asset-allocation group. Since stocks never reached historically low valuations after the three-year bear market, he expects the first part of the 21st century to be remembered as one of low returns. Yes, results have been strong over the past two years, but he characterizes the current decline in stocks as "the low-return environment strikes back."

It hasn't helped the market that debt levels among consumers continue to rise, while their confidence about the future weakens. The country's long-term economic picture is clouded by a soaring trade deficit and slumping dollar.

And the Federal Reserve is expected to continue its regimen of hiking short-term rates. The central bankers' stated goal is to get monetary policy back to a neutral level after injecting so much stimulus into the economy following the 2001 recession.


  Knight's biggest worry is that the Fed will go too far in hiking rates, sparking a recession. At its Mar. 22 meeting, the Fed is expected to signal a more aggressive stance in fighting inflation (see BW Online, 3/21/04, "How to End the 'Measured Pace'?"). Given this confluence of events and trends, stock strategists are extra-cautious.

"We'll probably have some tough going in the near term," says Nicholas Bohnsack, investment strategist at International Strategy & Investment, a New York research firm. That pressure could last at least until oil stops dominating the news.

Even well known bulls like Joseph Battipaglia, chief investment officer at Ryan Beck & Co. (BBX ), advise caution as the slide persists. "If you're trading the market, you have to play the current trends," he advises.


  Many strategists expect the market to stabilize before spring is out, however. Even if oil rises to trade in the $60s, $70s, or higher, contrarians are betting the price will come down, mainly because it's rising so fast --from $47 to nearly $58 a barrel in just a month.

"That sort of vertical price rise tends not to be sustainable," says Barry Ritholtz, chief market strategist at Maxim Group. "Oil is self-correcting," he says. "Once the price gets high enough, people start using less of it, and the economy slows down."

Plus, earnings season is around the corner and should be a positive factor for stocks. Bohnsack says negative preannouncements are running slightly above average for the first quarter, which bodes well for the markets during reporting season. In a case of reverse logic, "the bar is lower, which gives companies a greater opportunity to surprise to the upside," he says.


  Gail Dudack, chief investment strategist with SunGard Institutional Brokerage, also thinks the April earnings season will divert investors' attention from oil. She expects crude to fall in anticipation of warmer weather, coming back down to the $45 or $50 range by summer.

The longer-term outlook? Battipaglia thinks the market will be up 8% to 9% by yearend, with the S&P 500 at 1,300, thanks to factors like an improving labor market and corporations starting to spend the mountains of cash they have sitting on their balance sheets. "Saying the market will go down substantially from here is a hard case to make, based on fundamental evidence," he says.

But Battipaglia expects a few trips up 5% or down 5% during 2005, much like last year. "It will be a decent year," he says, "not one for the record books."

Smart investors may want to brace for a bumpy spring ride, with a fair amount of volatility and small, if any, gains in the near future. As always, good stock-picking should still pay off.


  Putnam's Knight says he's emphasizing high-quality, dividend-paying stocks in his portfolios and increasing the weightings in international stocks and bonds. Technology and financial sectors are suffering now, but energy and materials sectors are rising sharply.

"There are still some stocks that are doing well and a lot of good opportunities around the world," says Knight. That's some encouraging news to keep in mind -- even if the stock market continues to slide for a while from here.

Stone is a senior writer for BusinessWeek Online in New York