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Rates are Wall Street’s new worry

A wave of upbeat economic news has failed to lift stocks in recent weeks. Analysts say investors are worried that an improving economy may soon force the Federal Reserve to raise interest rates. — By Roland Jones
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A wave of upbeat news about the U.S. economy has swept though the financial markets in recent weeks, but none of it has lifted the stock market appreciably. One reason, say analysts, is that investors are worried that an improving economy may soon force the Federal Reserve to raise interest rates, a move that could choke off the robust recovery in share prices over the past year.

Stocks have traded in a narrow range for about a month, and while most Wall Street strategists agree the market is experiencing a period of consolidation after an eight-month rally that has driven the Standard & Poor’s 500-stock index, a broad gauge of the overall stock market, up a hefty 32 percent, others say interest-rate jitters are also to blame for the stalling market.

The concern: Good economic data — including a report showing the economy added about twice as many jobs as economists expected in October — may lead the Federal Reserve to raise interest rates earlier than originally thought, perhaps as soon as this March.

Rising interest rates usually hurt stock prices because they diminish the value of companies’ expected future earnings and increase borrowing costs for businesses. So with share prices riding high, some market strategists are worried that the future course for stock prices will be downward.

“The upside in the stock market is very limited right now,” noted Peter Boockvar, equity strategist at Miller Tabak, in a recent interview on CNBC.

“At a minimum this rally is topping out,” Boockvar continued, adding that stocks have rallied in anticipation of an economic recovery the evidence for which is already at hand. “Now we’re facing the risk of higher interest rates and the possibility that this economic recovery we’re seeing won’t last,” he added.

But not everyone on Wall Street is worried. For some sanguine market strategists, a modest hike in interest rates will merely confirm the economy is in recovery mode, which in turn should boost stocks. They also point out that, historically, the stock market rarely performs poorly in a national election year.

Rate hike speculation
Speculation that the U.S. central bank may soon start signaling an inclination to raise its key Federal funds rate, now at a 45-year low, has grown in recent weeks, fueled by news that the U.S. economy grew at its fastest pace in nearly 20 years in the third quarter. Rate hikes last week by the Bank of England and the Reserve Bank of Australia have added to the speculation, but Fed Chief Alan Greenspan has not hinted he plans to follow suit.

Still, a recent survey by Reuters shows found financial professionals essentially split three ways about a rate hike timing, with some expecting it in the first half of 2004, some in the second half and some not until 2005.

Kent Engelke, a stock market strategist at Anderson & Strudwick in Richmond, Va., thinks the Fed is likely to raise rates at its meeting in March 2004 and will use its late-January meeting to signal its intentions by omitting routine wording in its customary statement that says the Fed is able to keep rates on hold for a “considerable period.”

“The Fed wants to prepare the market,” said Engelke, adding that, historically, the stock market has declined by between 5 and 7 percent after a rate hike. “But I think the inverse will happen in 2004 because it will give the all clear signal to investors that the Fed is ahead of the curve and no longer thinks the economy is in danger,” he added.

Another reason for Engelke’s bullishness: Since 1960, stocks, as measured by the Dow Jones industrial average, have declined in only three national election years — in 1960, 1984 and 2000, according to the Stock Trader’s Almanac. “I believe 2004 will be another up year for the stock market,” said Engelke.

He said specific stock sectors helped by a rate hike include community banks, which will see improved spreads between their assets and liabilities. Also, evidence that the economy is starting to hum should also benefit telecom and technology stocks, as capital spending recovers. Hotel and leisure stocks will also be beneficiaries, as people feel better about the economy and take more vacations, Engelke said noting owns stocks in all of these sectors.

Housing stocks, by contrast, are likely to suffer, he said, as they have already seen a big gains this year amid low mortgage rates.

Fed fine-tuning
A.C. Moore, an investment strategist at Dunvegan Associates in Santa Barbara. Calif., doesn’t see rising interest rates as necessarily a positive for the stock market, but he thinks stocks are still reasonably valued relative to fixed income, and so doesn’t expect a significant sell-off after a rate hike. “The Fed is not trying to cool the market down; they want to reflect the cost of doing business in a more vibrant economy,” he said.

Other Wall Street strategists think the stock market may come under pressure if the Fed raises rates, and so the Fed is likely to remain on hold until at least the end of 2004. They point out that there are still concerns that economic growth may stall, and add that inflation is tame, so a rate rise is not needed. They also conjecture that the Fed is unlikely to put stock prices at risk in an election year.

Bill Dudley, chief economist at Goldman Sachs, thinks the Fed’s on hold throughout 2004 because if interest rates are raised the market will anticipate a whole series of rate cuts, which could put excessive pressure on the stock prices, he said on CNBC this week.

Another issue that may keep the Fed on hold is a troubling decline in bank lending according to Hugh Johnson, chief investment officer at First Albany. Rising interest rates increase borrowing costs, and economic growth is primarily driven by borrowing and spending, he noted. A continued decline in borrowing could eventually translate into a softer earnings performance in 2004, he added, and this would certainly drag stock prices down.

“Yes, employment is improving and, yes, the economy is strengthening, but there will be a valuation worry for the stock market if we don’t see earnings that are as good as the market expects,” said Johnson. “I hope the Fed isn’t seduced into raising rates because it will aggravate this liquidity problem.”

Technical analysts like Jeff deGraaf at Lehman Brothers, who pour over statistics and charts to try and deduce the market’s future path, also think stocks look vulnerable going into 2004.

Low quality stocks are outperforming high quality stocks, said deGraaf, because they are benefiting from monetary and fiscal stimulus. But there is some question as to whether investors will rotate funds into more stable equities, he noted.

“We’re looking at a good year in equities on a historical basis, but people are waiting to see if it’s sustainable for a few more quarters,” deGraaf said. “The trends are in place, but the momentum of the market is looking tired on the upside and that’s not a common characteristic of a bull market.”