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Get ready for another late rally
Stocks are almost exactly where they started the year. But last year's fourth quarter saw a rally, and we'll see one this time, too -- followed by a sour 2006.
By Jon D. Markman
Despite hurricane-force winds, tremendous corporate profitability, a strong economy and buoyant investor sentiment, the stock market has gone absolutely nowhere this year.
Weird, huh? You could have slept through the first three quarters of the year and not missed a thing. The S&P 500 ($INX), representing large U.S. companies' shares, is up less than a quarter of a percentage point, while the Russell 2000 ($RUT.X), representing small companies' shares, is up around 0.6%.
Now here's something that's maybe even a little stranger. The market was in exactly the same shape last year at this time -- precisely flat. The S&P 500 opened for business on the day after New Year's in 2004 at 1,111 and closed on Sept. 28 at 1,110. The Russell 2000 opened 2004 at 556 and closed Sept. 28 at 558.
All that lateral travel was just about to end last year at this time, as small stocks ultimately rallied 15% in the last quarter of 2004 and large-cap stocks rose about 9%. And the same is probably about to happen now, with a diabolical twist.
A sea of change
With the caveat that it's easier to become U.S. chief justice than to foretell markets, I will venture out on a limb and forecast that shares are about to enter a short period of intensely nauseous churn, but will end the year a tad higher -- perhaps as much as 5% higher. Nothing to write home about, but better than a poke in the eye with, well, a sharp stock. After that, 2006 will hit investors right between the eyes, leaving them with losses in the low double-digits.
In boaters' language, we are about to witness a battle between wind and tide. The wind blowing U.S. companies forward is strengthening global demand for electronics, houses, toothpaste, movies and furniture because of the materialistic aspirations of emerging markets' middle classes. This is not speculative blather about China, India and South America. It is real, and it is happening.
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The tides pushing companies back to shore are: Federal Reserve Chairman Alan Greenspan's zeal to deny those very things to the middle class in the United States by raising interest rates over his head like an carnival muscleman; a continuing escalation in oil and gas prices; a runaway federal deficit that draws funds away from more productive uses; and a persistent erosion of job growth and consumer confidence.
My guess is that the wind will battle to a tie through the end of the year, but the tide will succeed in the end because, eventually, the Fed virtually always gets its way, and because the market typically stumbles in the second year of a presidential administration -- 1990 (-9%), 1994 (-2%) and 2002 (-23%) being prime examples.
Here are four guideposts for the coming turbulence:
1. Earnings growth surprises to upside
In June, analysts estimated that S&P 500 companies' earnings would rise 15.1% (annualized) in the third quarter. But it looks like they're coming in at more like 17.9%, according to Thomson Financial Research. A lot of that is energy, of course, with some major oil companies' earnings estimates up 29% to 56% in the past three months (the highest for any sector since early 2003). Despite the depressing effect of Hurricane Katrina on insurers, financial companies are also expected to come in strong, with a 21% annualized growth rate -- primarily due to easier comparisons to last year, when insurers suffered through a series of Florida hurricanes.
On the downside, according to Thomson data, the sectors most likely to suffer stumbles are chemical and other basic materials makers, which are forecast to see income decline by as much as 5% overall, and consumer discretionary companies such as General Motors (GM, news, msgs) and Walt Disney (DIS, news, msgs). Look for modest gains in the third quarter, but warnings of poorer results ahead in the fourth quarter and 2006.
2. Energy stocks surprise with more upside
This is a tricky one. Energy exploration companies' third-quarter earnings will show a big boost due to higher prices for crude oil and natural gas. Many cynics will figure that this is already discounted in the stock prices, and figure the sector will sell off as energy prices moderate. But it's really not that simple. As explained in my column three weeks ago, commodity producers are alone in the investment universe in their ability to secure future selling prices for their output. A couple of years ago, most of them sold two years' worth of their output for what seemed then to be very high prices in the $25-$35 range. So many have not even seen the benefit to their bottom line of $40 oil and $8 gas, much less $65 and $12. As those "collars" roll off, earnings growth will be off the charts, and current valuations will seem cheap. Strange as it sounds, this isn't in a lot of the stocks yet, so their prices can still go much higher even if the commodity flatlines. They're still the top pick of our StockScouter stock-rating system, as they have been for two years.
3. TV over Internet is a hit
Every quarter needs a new-technology star, and this could be it. In the mainstream, the hot electronics toys for the holiday are likely to be flat-panel TV screens and the Nano music player from Apple Computer (AAPL, news, msgs). But among institutional fund managers, more attention will flow to a technology called IPTV, which is short for Internet Protocol Television.
Quick bit of background: Cable television and regional Bell operating companies are in a life-and-death battle to be the leading provider of the "triple play" of telecom services to homes: data (broadband); voice (telephone); and entertainment (TV). For cable companies, data and entertainment are easy, while voice is hard. For phone companies, voice and data are easy, while entertainment is hard. Cable companies are shouldering into the voice business via voice-over-Internet initiatives (along the lines of super-startup Vonage). And now phone companies are trying to muscle into the entertainment biz with experiments to shoot television signals through their fiber-optic networks and DSL connections into customers' TV sets. If they're successful, TV will never be the same, as customers will come to exert complete control over what they watch and when they watch it; it's TiVo on steroids.
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