Steady on Stocks: More Gains Ahead

From Standard & Poor's Equity Research

On May 5, the U.S. equity markets soared on expectations that the Fed's widely anticipated 16th consecutive rate hike on May 10 would be the last -- possibly for this quarter, and more likely for this rate-tightening cycle. Come the day after the actual rate hike, however, the markets slumped on renewed inflation worries, in our opinion, sparked by surging oil and gold prices, which reaccelerated chatter about additional future interest-rate increases. For the week ended May 12, the S&P 500 gave back 2.6%. Ouch.

This heated "inflation's here/no, it's not" banter has been on the tip of investors' tongues since January, 2005, and isn't expected to die down anytime soon. So while we wait for a pause in the shouting, let's review where we've been since the Fed started raising short-term interest rates in mid-2004.

If you asked investors in June, 2004, what would happen to the growth of the U.S. economy in general, and corporate earnings in particular, as well as what the S&P 500 and its constituents would do after the Fed had raised interest rates 16 straight times and pushed the Fed funds rate from 1% to 5%, I think it would be fair to say that most would have expected the economy to slow, corporate earnings to slump, and share prices to tumble. And they would have been wrong.


  Since June 30, 2004, U.S. gross domestic product has expanded 10%, operating earnings for the S&P 500 have jumped 30%, and U.S. equity markets gained anywhere from roughly 10% to 31%: The Nasdaq gained 9.6%; the S&P 500 rose 13%; and the S&P MidCap 400 Index jumped 30%, only to be edged out by the S&P SmallCap 600 Index's gain of nearly 31%. And that's not to mention the MSCI-EAFE's ETF (EFA) advance of 49% and the MSCI-Emerging Market's ETF meteoric advance of 98%.

What's more, all 10 sectors in the S&P Composite 1500 Index posted price increases, with Health Care eking out a 1.3% rise, while Energy soared 72%. And finally, 77% of the 121 subindustry indexes in the 1500 posted advances, led by more than 100% gains for copper and steel stocks, oil & gas drillers and refiners, as well as agriculture-products issues and railroads. More than 10 subindustry indexes posted double-digit declines, led by automobile manufacturers, brewers, and airlines.

So what's next? The biggest hurdles to overcome, in our opinion, are oil prices and the threat of accelerating inflation. From a technical standpoint, we see oil prices easing over the coming months. Mark Arbeter, S&P's Chief Technical Strategist, recently identified a double-top formation in prices for the benchmark West Texas Intermediate (WTI) grade of crude oil, and now forecasts that prices will decline to the $60-$63 per barrel area in the intermediate term. From a fundamental perspective, S&P and Global Insight project WTI oil prices will average $62.13 in 2006 and end the year close to that level at $61.75. For 2007, we see prices averaging a shade below $60 per barrel.


  Also, S&P and Global Insight project global oil demand will increase 1.79% in 2006, vs. the 1.24% growth recorded in 2005. Therefore, it appears to us that while oil demand will stay firm in 2006, owing to healthy worldwide economic growth, we see prices coming off their highs and trading closer to their fundamentally justified levels, which we think will soothe otherwise anxious expectations.

On the inflation front, S&P's Chief Economist, David Wyss, expects the economy to slow fairly abruptly in the second half of this year as the housing market slides and consumers finally become more realistic about their spending. He forecasts real GDP to slow to 2.75% in the second half of 2006, from 4.25% in the first half. Slower growth in consumer spending and a drop in housing activity should be partially offset by less drain from trade and stronger business investment.

Core consumer price inflation has edged up to 2.1% from 1.8% a year earlier. Wyss expects it to reach 2.5% by yearend. Inflation is a lagging indicator, and if the Fed chases the inflation rate too closely, it will overreact and raise interest rates too much. If the evidence of slowing growth is clear enough, the Fed will be able to stop rate hikes, in our opinion. However, if the evidence is unclear or the economy continues to surprise on the upside, the Fed will probably go too far, raise rates to 5.5% or higher, and then have to loosen them in 2007.


  So, even though the evidence isn't overwhelming that oil prices will tumble immediately and inflation worries will evaporate overnight, we believe the technical signals from oil-price charts, combined with the projected slowdown in U.S. economic growth, will ultimately ease the concerns over oil and inflation and allow equity prices to work their way higher in the quarters ahead.

As a result, S&P is maintaining its positive outlook on equities. In fact, on May 10, S&P's Investment Policy Committee voted to raise its mid-year target for the S&P 500 to 1345 from 1325, and its year-end target to 1385 from 1360, citing stronger-than-expected corporate earnings, an expected moderation of oil prices, and the end of the Fed's rate-tightening program. Six-month and full-year price gains are now projected at 7.8% and 11.0%, respectively.

Industry Momentum List Update

For regular readers of the Sector Watch column, here is this week's list of the industries in the S&P 1500 with Relative Strength Rankings of "5" (price performances in the past 12 months that were among the top 10% of the industries in the S&P 1500) as of May 12, 2006.