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Economy, stocks could rebound — maybe

Everything seemed to be going well for the stock market this year, until last month. What does that mean for the rest of 2006?
/ Source: The Associated Press

Question: Everything seemed to be going well for the stock market this year, until last month. What does that mean for the rest of 2006?

Answer: Despite Wall Street’s nervousness about interest rates, inflation and an economy expected to start slowing down by the end of the year, many analysts remain bullish on the second half of 2006 — if all goes well.

Scott Wren, equity strategist for A.G. Edwards & Sons, said the brokerage firm is still looking for the Standard & Poor’s 500 index to reach 1,400 by year’s end. That would be a 14 percent jump for the year as of Tuesday; the S&P was down 2 percent for the year as of the close of trading.

“We’re still seeing decent economic growth for the full year, corporate earnings around 8 percent or so, and the stuff we’ve been looking for seems to be continuing to pan out,” Wren said. “It’s pretty realistic, I think.”

The stock market, of course, is a barometer for the overall economy, and despite a slowdown in the housing market and high energy prices, the U.S. economy is still expected to grow 3 to 3.5 percent for the year, according to Putnam Investments economist David Kelly.

That is in line with the 3.2 percent historic average, Kelly said.

“This is not a booming economy at all, but that’s fine. It’s still growing,” Kelly said. “The economic fundamentals justify a stronger stock market, perhaps leading to a nice second-half rally.”

Now, however, comes the “if all goes well” part. Market watchers see two potential problems that could derail Wall Street’s prospects for a strong second-half of the year. One is that the Federal Reserve could go too far in raising interest rates. And there is growing concern that the nation’s monetary policy body could do just that.

“The big concerns are how much inflation are we going to have, what’s the Fed going to do about it, and how much is the economy going to slow,” Wren said. “You’ve got a lot of Fed governors and (Fed Chairman Ben) Bernanke out there talking tough on inflation, and that’s what scared the market over the past month or so.”

One of the Federal Reserve’s primary missions is to keep inflation in check. While many on Wall Street see the Fed as having another role — ensuring a healthy economy — inflation takes precedence. Bernanke, a former academic with a strong appreciation of the Fed’s historic role in the nation’s economy, is unlikely to allow inflation to get out of hand on his watch, even if it means slowing the economy more than investors would like — or stopping economic growth entirely.

The nation’s benchmark lending rate currently stands at 5 percent, and the Fed is expected to hike rates by a quarter percentage point at its meeting June 28-29. That would be the 16th straight hike.

“If they go to 5.5 or 6 percent, then they’ve gone too far,” Kelly said. “And if they come back around in November and are forced to cut rates, then that’s a huge psychological blow to the economy and the stock market.”

Lack of confidence in Fed policy is one risk to the market for the rest of the year. Another is what traders call “geopolitical risk” — unexpected world events that can crush investor sentiment. The 9/11 terror attacks are an extreme example, but continuing instability in oil-producing countries like Venezuela and Iran could also pressure stocks.

“I think certainly if we get some cutoff of oil supply from (Venezuelan President) Hugo Chavez or Iran, that’s going to have very negative implications for the economy and for stocks,” Wren said.

Even without an actual event happening, investors are likely to turn to more defensive investments in the second half of the year as they cut down on risk. Sectors like consumer staples and health care are expected to outperform riskier stocks, especially smaller company shares and those in the tech sector.