Reading the market tea leaves

When financial analysts talk about the future, what they don’t say is sometimes even more important than what they do tell us. That was my feeling recently after listening to the comments of Sam Stovall, chief investment analyst at Standard and Poor’s.

The event was a high-tech conference call for financial professionals and the business media. While Stovall was reading the market tea leaves, we were able to follow his power point presentation through a special Internet link.

The overall tone of his message was positive. Despite the worries facing the markets, the rest of 2004 should be pretty good for investors. His year-end target for the S&P 500 is 1,215 which would be an increase of about 8.5 per cent from the level at the time he spoke. His Nasdaq target is 2,225, which would be a 12 per cent upward move.

Stovall, who is the author of The Standard and Poor’s Guide to Sector Investing, used a dazzling array of statistics and projections to bolster his case. Capital spending will rise almost 14 per cent this year, he forecast. S&P 500 earnings per share will increase by 19 per cent. The price/earnings ratio for the S&P is 19, which is bew average (meaning stocks are relatively cheap). Real GDP growth in the U.S. this year will be 4.8 per cent. All good signs for the markets.

Moreover, Stovall, who is a student of market history, says the past is on our side. The second year of a bull market, while generally not as good as the first, still tends to be quite strong. Presidential election years usually produce rising markets, with an average gain of 8.6 per cent from 1944-2003.

All in all, the prospects are bright — at least for 2004. “I’m fairly optimistic for this year,” Stovall concluded. “In the near term, markets will be able to overcome that wall of worry.”

What he did not say was what he expects to happen in 2005. But some of the numbers he produced told their own story. Some examples:

· Real GDP growth in the U.S. is expected to slow to 3.5 per cent in 2005. The growth in consumer spending will fall a full percentage point, from 3.9 per cent to 2.9 per cent. Equipment investment, projected to increase 13.9 per cent this year, will decelerate to an 8.5 per cent advance next year.

· Inflation will slow to 1.5 per cent in the U.S. in 2005 but yields on 10-year bonds will increase by a full percentage point to 5.6 per cent. Stovall didn’t say as much, but this clearly would increase the attractiveness of bonds relative to stocks.

· S&P earnings per share (EPS), which are increasing at a rate of 19 per cent this year, will pull back to an 11 per cent increase in 2005. Energy stocks will actually experience a decline of 10 per cent in EPS next year. 

· Historically, periods when interest rates are rising are negative for stock prices.

From 1970 to 2000, the S&P 500 fell by 5.8 per cent on average in the 12 months following the first of a series of rate hikes by the U.S. Federal Reserve Board. Stovall predicts the Fed will raise its key rate by three percentage points in the next two years, which would take it from 1 per cent to 4 per cent. Financial, industrial, and consumer discretionary stocks are the most vulnerable in this situation.

· Market history raises the possibility that we could be in a sideways cycle that could last 20 years. During this period, stocks may show a great deal of short-term volatility but the overall trend remains flat.

· The first two years of a presidential term are normally the worst ones for the markets. Moreover, whenever an incumbent president is defeated, the S&P 500 has dropped 4.7 per cent in the subsequent year. George W. Bush faces that possibility as the Iraqi debacle worsens.

So what are we to make of all this? The prudent investor should take Stovall’s analysis as a warning sign. Stocks may stage an impressive rally, as the second and fourth quarters are historically very strong in an election year. That will be a signal to take some profits, since 2005 isn’t shaping up as very promising, especially if Bush loses. 

Of course, all this can change in a minute. A major terrorist attack on the scale warned of by the U.S. Attorney-General last month would throw all the projections out the window. So would a decision by the Fed to either delay interest rate increases or accelerate them. As we have learned in recent years, sometimes painfully, nothing can be taken for granted.

But if, for once, the financial world unfolds as expected, then it looks like we have one more chance to make some good profits in the stock market. Then it will be a case of pulling in our horns for a while and waiting for new opportunities. In the interim, fat bond yields will help to ease the transition.

Adapted from an article that originally appeared in the Internet Wealth Builder.