Death on the Gulf, Delight on the Street

The market's surge doesn't mean investors' relish disaster, just that they see cheaper oil and low rates not so far down the road

By Amey Stone

The day hurricane Katrina turned the Gulf Coast into the nation's costliest disaster zone was, in retrospect, a great time to buy stocks. In the storm's aftermath, as New Orleans was rendered a swampy ghost town, gas prices soared above $3, Congress contemplated recovery costs that could raise the national deficit by $100 billion, and TV sets around the world were tuned to scenes of Armageddon-like destruction and despair.

Nonetheless, stocks steadily rose. By Sept. 9, the Dow Jones industrial average had gained nearly 300 points since Katrina struck and the S&P 500 notched a 3% gain.


  What fueled such enthusiasm at a time of such calamity? Investors and analysts offer two main reasons: The expectation that the Federal Reserve will soon stop raising interest rates and the likelihood that oil and gas prices will quickly fall back to pre-hurricane levels.

"My impression is that the market is correctly anticipating that the Fed is close to being finished with its tightening campaign," says Jason Trennert, chief investment strategist at New York research firm International Strategy & Investment Group. "The Fed may have one or two [rate hikes] left, but the punch line for investors is that the Fed is done."

Continued low interest rates would be a major relief to stock market investors who fear that higher rates will kill economic growth, consumer spending, the real estate market, and corporate profits. Trennert predicts a "Goldilocks" scenario, one in which the economy slows enough to stop inflation while retaining sufficient strength to propel stocks. His yearend target for the S&P is 1325, up about 7% from the Sept. 9 close of 1241.


  Investors fully expect Katrina and the resulting spike in energy prices to hurt the economy. But many believe the economic consequences are short-term and gas prices will soon fall to pre-hurricane levels. "All told, if the government response is swift, and if gasoline prices fall back relatively quickly, the economy should maintain most of the momentum it had," David Kelly, economic advisor at Putnam Investments, wrote to clients on Sept. 6.

Indeed, investors were cheered that the price of crude oil closed Sept. 9 at $64.20 a barrel on the New York Mercantile Exchange, a nice drop from the high of $70 a barrel in the days after the hurricane.

"The stock market tries to see through the valley," says Nick Colas, director of research at New York-based Rochdale Securities. "Investors are forecasting conditions six months out, when the Fed should have stopped tightening, fiscal stimulus will still be in place, and long-term rates will be low. That should be positive for stocks."


  Strong profits and healthy corporate balance sheets are also helping investors keep the faith. "The market fundamentals are really strong," says Doug Cote, senior portfolio manager at ING Investment Management. "That is why the market is inching forward in spite of these shocks." He points to attractive stock prices, broad-based earnings growth, and a market with diversified strength across many sectors (rather than concentrated in tech, as was the case in the late 90s). "God forbid there is another shock or surprise, but the market can withstand it," he says.

Market action is also signaling more gains for stocks ahead, believes Barry Ritholtz, chief market strategist at investment firm Maxim Group. He cites positive technical indicators, like major indices reaching new highs. "It's hard to imagine a significant sell-off when the trend is up and market internals are so strong."

Just because investors have been resilient in the face of calamity so far doesn't mean they will remain so, Ritholtz warns. He notes that the market has seen delayed response to similar shocks. He looked as far back as the 1906 San Francisco earthquake to see the market's reaction and found stocks took nearly a year to react to the full economic impact of that crisis. Also, after the Arab Oil Embargo of 1973, stocks were flat for two weeks -- until investors realized what gas shortages would mean to the U.S. economy. "Then investors gave up the ghost," he says. "I suspect we're looking at a similar situation."


  He thinks investors reaction to Septer 11, when stocks crashed as soon as markets reopened, was so harsh and immediate mainly because the terrorist attacks were much more shocking and frightening than the hurricane.

Some analysts think the Fed could surprise investors by signaling at its Sept. 20 meeting that more rate hikes are on the way (see BW Online, 9/8/05, "A Fed Pause? Don't Count on it"). Rochdale's Colas worries that the government will spend so much on the recovery to improve the public's perception of its handling of the disaster that it will kindle inflation, forcing the Fed to keep raising rates.


  For now, while investment strategists at firms including Charles Schwab and Lehman Bros. recommend that investors emphasize stocks over bonds and cash in their portfolios, they are sounding some cautionary notes. "The bottom line: Energy costs remain the key variable for determining the outlook for the economy and the financial markets," wrote Schwab's chief investment strategist Liz Ann Sonders in a Sept. 8 report.

If reasons for investors' optimism fail to materialize in the next few weeks -- including a slowing of the Fed's pace of rate hikes and falling gas prices -- the market could easily change course. For investors thinking about getting in now, cautious optimism is the rule of the day.

Stone is a senior writer with BusinessWeek Online in New York

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