A turning point in the cycle
Many years ago, when I was an English literature student in college, I became a great fan of the poems of T.S. Eliot. One of my favourites was The Waste Land which opens with the classic line: “April is the cruellest month…”
I know that Eliot was not thinking about the stock market when he penned that line, but it certainly seems fitting for the month just ended. April was indeed cruel to investors. Just look at the numbers for the major North American indexes.
Dow Jones Industrial Average down 1.3 per cent
S&P 500 Index down 1.7 per cent
Nasdaq Composite Index down 3.7 per cent
S&P/TSX Composite Index down 4 per cent
The only good news was that European markets held up reasonably well as did the Tokyo Nikkei Index. But the Hang Seng in Hong Kong took a drubbing, falling 5.8 per cent on the month after the Chinese government announced it is taking steps to curb what it fears may become runaway economic growth in the country. That move also socked commodity stocks, which had been riding high as the demand for raw materials from China continued to escalate.
The big drop in the S&P/TSX Comsite can be attributed in large part to the weakness in resource stocks and the implosion of Nortel. The S&P/TSX Capped Metals and Mining Index plunged 8.7 per cent last week, according to Globeinvestor.com. But even that looked like a hiccup compared to the 16.3 per cent slide in the Capped Information Technology Index, of which Nortel is a major component. In fact, not a single TSX sub-index finished in positive territory last week, although the Capped Utilities Index just about broke even. That was a bit of a surprise given the growing concern over higher interest rates on the horizon and the negative impact that usually has on utilities stocks.
In New York, the market turmoil had different causes. Despite some excellent earnings reports, which show the U.S. economy is continuing to gain strength, investors seem to be more concerned about three other issues.
1. Iraq and terrorism. It is becoming increasingly obvious to anyone who looks at the situation objectively that the U.S. has gotten itself into a hell of a mess in Iraq and that getting out of it with dignity is going to be expensive, both in terms of lives and money. It also appears that, instead of helping to defeat terrorism, Iraq has strengthened hatred of the U.S. in the Arab world and created many new recruits for Al-Qaeda and similar terror organizations. That can only cause nervousness and uncertainty in investors’ minds.
2. Interest rates. At the start of the year, it seemed that investors weren’t the least bit concerned about the potential for higher rates as the economy strengthened. Now they have swung to the other extreme – they almost seem to be panicking at the prospect.
3. Inflation. The ever-rising price of gas is starting to hit home and there is no relief in sight. Recent U.S. inflation numbers now look almost scary and the U.S. Federal Reserve Board, which was so concerned about the possibility of deflation a year ago, now appears to have virtually eliminated that scenario from its thinking.
As we have been told repeatedly over the years, stock markets must always climb a proverbial “wall of worry”. Right now, that wall looks imposingly high. But we need to keep things in perspective. We are at a turning point in the current economic cycle, one which we have seen many times over the decades. We are emerging from a prolonged period of economic slowdown and deflationary fears into a new era of growth and rising inflationary expectations. The changes that occur in the markets whenever this occurs are natural and, to a degree, predictable.
The stock markets are leading indicators. The big rebound we saw in 2003 was the precursor to the improving corporate financial results we are seeing now. The correction and consolidation period that we have experienced in the past two months is part of the normal pattern that occurs at this stage in the cycle.
The securities that performed best when the economy was in a funk and pessimism reigned supreme have had their run. That includes bonds, income trusts, utilities, and bank stocks. The next stage should see strong performances from such sectors as resources, consumer goods, retailers, and industrials. I would add high-tech to that list had it not already experienced such a strong recovery.
That doesn’t necessarily mean you should do a complete portfolio housecleaning. Some stocks and income trusts are worth holding for the long term because of the nature of their business and the dependability of their cash flow. But you should certainly take a close look at everything you own and see if you want to continue to maintain your position in this changing environment.
Just remember that terrorism remains the wild card in the whole equation. All the current assumptions could be thrown out the window if there is a major attack in the U.S. No one wants to contemplate that happening, but every prudent investor must allow for the possibility.
Adapted from an article that originally appeared in the Internet Wealth Builder.