On the Street, More Treat Than Trick

Amid all the uncertainties buzzing about the economy -- inflation, political upheaval, a new hand at the Fed -- one fact is beyond dispute: Stocks are relatively cheap

By Amey Stone

So far, October has been one long fright night for stocks. While the month that ends with Halloween is often a ghoulish stretch, this year brought more than its share of natural, political, and economic scares, including deadly hurricanes, a White House scandal, Federal Reserve Board turmoil, a topping out of the housing market and -- most fearsome for investors -- a pick-up in inflation.

But as the 173-point jump in the Dow Jones industrial average on Oct. 28 shows, investors may have become overly spooked well ahead of Halloween.


  Despite worries about the future, the current backdrop for stock investing remains positive: Robust economic growth, weak inflation, and still-low interest rates provide an ideal mix. The Fed is likely to keep raising rates, but that's due to a strong economy, and as long as it doesn't overdo it, stocks can still perform well.

What's more, thanks to the frightful times, some stocks are attractively priced. The Standard & Poor's 500 index has an average price-earnings ratio of 15, about even with historic averages. Many big name growth stocks are downright cheap (see BW Online, 8/18/05, "Some Fat Chances for Investors"). A long-predicted decline in corporate earnings has yet to materialize and third-quarter results show that many companies have posted surprisingly good results.

Pick the right stocks and you'll do just fine, argues investment strategist Peter Cohan of Marlborough, Mass. He says he has been amazed at how well tech stocks have done lately. "The fundamental assumption was that anything related to energy would go up, everything else go down," Cohan says. But he notes that stocks like Google (GOOG ) (which he doesn't own), Adobe (ADBE ), and Macromedia (MACR ) (which he does own) are doing well.


  "Now energy is taking a hit and tech is doing quite nicely," he says. "I'm pleased about that." Adobe is in the process of completing its purchase of Macromedia, clearing one of the last hurdles on Oct. 13, when the Justice Dept. signed off on the deal (see BW Online, 10/13/05, "Adobe's Macromedia Takeover Gets DOJ OK").

Barry Hyman, equity market strategist with New York investment firm Ehrenkrantz King Nussbaum, thinks the stock market, which typically moves six months ahead of the economy, is transitioning from favoring sectors that do well at the end of an economic cycle -- like energy and industrials -- to looking past an impending slowdown and favoring stocks that prosper when economic growth resumes, like technology.

"That process takes one or two quarters" and it can include a fair amount of volatility, says Hyman. With the shift in Fed leadership to Greenspan's heir apparent, Ben Bernanke, and worries about inflation, "There are a lot of obstacles in front of the market as it adjusts to a slowing economy and higher interest rates," he says.


  Hyman thinks there will be fits and starts in stock performance, but that the Dow -- down 3.5% so far in 2005 -- will end the year up slightly. "In a transition period, it's hard for the market to gain steam and take us to new bull market levels," he observes. Hyman isn't expecting a serious downdraft.

After all, two of the big worries plaguing stocks this Autumn -- higher energy costs and waning consumer spending -- are already turning the corner. Gasoline prices are now about 50 cents lower than post-Katrina highs and likely to head lower. Analysts see that trend easing pressures on consumers just in time for the holidays.

Inflation has been investors' main worry in the past two weeks. But the Oct. 28 report on third-quarter gross domestic product (GDP) showed surprisingly strong growth and few signs of inflation. Given the increasingly global work force and the shifting of operations to lower paid workers in Asia and India, it seems unlikely wages in the U.S. will accelerate enough to lead to crippling inflation. The airline and auto industries provide poignant examples of how workers today have to give up pay and benefits in order to keep their jobs.


  Still, some investors fear that the Fed will raise rates too high and throw the economy into recession. But it seems more likely the Fed will stop raising rates soon. Moody's Investors Service's forecasts "improved performance by equities in response to an end to the current series of Fed rate hikes." On Oct. 28, Moody's analysts wrote: "Provided that the Fed does not tighten monetary policy aggressively, the outlooks for both the economy and corporate earnings are favorable. Unless wage growth accelerates, a forthcoming rise by core price inflation ought to peter out."

Another doomsday scenario that has investors on edge -- a crashing real estate market -- also seems unlikely. The current gradual cooling seems like just the right medicine for reducing the speculative fever in real estate -- and avoid a bursting bubble (see BW Online, 10/28/05, "Housing Leaks a Little More Steam").

Upcoming economic reports (see 10/31/05, "Vital Signs for the Week of Oct. 31") and meeting of the Federal Reserve Board on Nov. 1, could trigger renewed selling if signs of increased inflation coupled with economic weakness emerge. The market got a scare when durable goods orders were much weaker than expected on October 27 -- a report quickly overlooked when the GDP report came out the next day.


  More problems for the Bush Administration, is another looming risk. Investors were relieved that only I. Lewis Libby Jr., chief of staff for Vice-President Dick Cheney, was indicted by a federal grand jury on Oct. 28, but the investigations continue.

For now, many strategists are sticking with their forecasts that the market will be volatile, but won't move too far up or down by yearend. "The bears have not been proven right," says Hyman. "At certain points, everything looked bad, but then it stopped going down, every time."

For now, cheap prices and a strong economy are a firm foundation for stocks. And investors willing to go against the grain, may find that this frightful season could be a good time to put some money in stocks after all.

Stone is a senior writer for BusinessWeek Online in New York

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