Bernanke: Investors' Foe...or Friend?

His comments about rate hikes and inflation send stocks tumbling or soaring. Investors should focus less on the Fed and more on corporate earnings

With a friend like Ben Bernanke, who needs the shorts? On June 5, the Fed chairman delivered a bombshell to investors, warning that there was "unwelcome" news about inflation. That caused investors to overreact in the days immediately thereafter, with the market's 2006 gains wiped out. But on June 15, Bernanke was singing quite a different tune. In a speech that day before the Economic Club, he said inflation expectations have "fallen back somewhat." That looked like a god-send to investors. It sent the market soaring that day by more than 180 points in the Dow Jones industrial average.

What is going on with Alan Greenspan's succsssor? What is he really saying? For a while investors were asking whether or not the bull market was over. The huge one-day rally on June 15 gave the bulls badly needed relief. Although some investors continue to be nervous, as evidenced by the market's drop on June 16, the market's fast upward overdrive appears to affirm that a new bear market is not yet upon us. Indeed, this may be the time for you to catch some falling stars--before they bounce up again.

In his June 5 speech at a panel of the International Monetary Fund in Washington, the "mouth of the Fed" (as one observer described him) said the rise in inflation measures was "unwelcome," and that the Fed will be "vigilant to ensure that the recent pattern of elevated monthly readings is not sustained." Wall Street interpreted those words as a definitive "no" to the oft-asked question of whether the Fed is done raising interest rates.

But in his June 15 speech, Bernanke tried to assuage investors' fears, which caused some pros to believe that the Fed may be rethinking its hawkish view on inflation and interest rates. Investor response clearly reflected that belief. The June 15 rally was also helped by technical factors. With the market having gotten hammered down so much, it was predictable that there would be a short-term snapback. That took the Dow back above 11000, to 11014.55, pushing the average up for a 2.8% gain in 2006. Before the big June 15 advance, the Dow had tumbled about 7% since May 11, when it hit its peak this year. The S&P 500 was down 5.5%, and the Nasdaq was off 10.1%.

Just to get a flavor of how Wall Street viewed Bernanke before June 15, here's what longtime Fed observer Bert Dohmen, editor and publisher of the Wellington Letter market newsletter, wrote on June 7: "My opinion of Bernanke is eroding even faster than the markets. He will now try to 'prove' that he is a 'macho' guy, even if it kills the economy. I predict he will go down in history as a short-term Fed chief, who was not up to the job, similar to G. William Miller in 1977-1978."


  Investment adviser Edward Yardeni said the question uppermost in investors' minds is: "Are we in the Bernanke Crash, similar to the Greenspan Crash?" Greenspan was at the wheel when the unexpected 1987 market crash occurred, and during the massive decline in 2000 after his controversial "irrational exuberance" statement about the market's upsurge during the late 1990s. On the flip side, however, Yardeni pointed out that corporate buybacks were going strong, as are corporate earnings.

And there are other pros who were optimistic before June 15. They saw the drop in prices as temporary, believing the market is poised for a big upward push, with the sell-off a logical prelude to the continuance of the bull market through 2007. "Relative to bonds, inflation, and earnings growth, the markets are no longer reasonably priced. In our view, they're now inexpensive," argued Zachary Karabell, senior economic analyst at investment-management outfit Fred Alger & Co. According to Karabell, investors are "too obsessed with the Fed."


  Karabell also dismisses the other issue that's has been roiling the markets here and abroad: inflation fears. On almost every score, "inflation is tame," Karabell asserts. He notes that companies still aren't passing higher energy and material costs on to consumers— nor are those costs meaningfully eroding corporate profits. Raw materials are usually less than 10% of a company's earnings, while labor is generally 70%. Labor costs have been manageable, running at 1.6% a year, figures Karabell, compared with last year's 3.4%.

And that's the good news the markets have largely ignored. The economy and corporate earnings have been growing in part because of the absence of strong wage pressures. Karabell notes that excluding energy companies, earnings for the S&P 500 were up 12% in the first quarter. When you include results from energy companies, earnings were up 14%. Karabell thinks double-digit earnings growth looks likely for the remainder of 2006.

As to the question of the Fed raising interest rates further, the thing to remember is that after 16 rate hikes to date, it's unlikely that a further 16 will follow. Another way to look at it: We're closer to seeing a peak—and near the end of the rising-rate cycle. The Bernanke statement on June 15 gave some credence to that idea.


  There's also the issue of whether the economy is slowing. Investors should realize that in past market cycles, stocks rose even when the economy looked sluggish. There are other factors, too, that affect the market in a positive way: modest valuations, depressed stock prices, rumors, speculation, and projections of higher corporate earnings. Remember: The stock market is often more inclined to respond to perceptions than to reality. Eventually, investors come down to recognizing reality. But perception usually comes first in divining how the market will move.

So one piece of advice to investors now: Quit obsessing on the Fed. Instead, focus more on corporate profits, which usually help propel the market higher. It looks like the market is oversold, as some market strategists suggest. The Fed will have to end its hiking mode sometime soon. And when it does, Karabell says, "Will it not be good to have a front-row seat?" So wouldn't it be nice if you bought your favorite stocks now when their prices are depressed?

Remember the one indisputable adage: Buy low, sell high. And now, even with the recent rally, there are many stocks look like they're real bargains.