As Fed meets, U.S. stocks see warning signs

By E.S. Browning
1401 words
30 October 2007

The U.S. Federal Reserve meets this week amid persistent signs of trouble in the stock market.
After the Fed's half-percentage-point interest-rate cut six weeks ago, major stock indexes rebounded, and the Dow Jones Industrial Average remains near its record high. But rising oil prices, mixed corporate-profit reports and the spreading effects of a housing slump continue to fuel tumult in the economy -- and some underlying patterns suggest that stocks may have trouble maintaining their high-wire act.

Major stock indexes are being supported by multinationals such as Microsoft Corp., Coca-Cola Co. and Procter & Gamble Co., which benefit from the strong global economy. Many other stocks, notably financial institutions and smaller companies dependent on the flagging U.S. consumer, have taken hits.

Other indicators also suggest thin support for the market. The ratio of the number of stocks rising versus the number that are falling has been getting worse since the spring, and the number of stocks at 52-week highs has been on the wane since last year.

"If you look at the economy, you see softening durable-goods orders, slowing manufacturing gains and a troubled housing market," says Russ Koesterich, head of investment strategy at Barclays Global Investors in San Francisco. "These problems are entrenched." Even if the economy escapes recession, he worries, "we could face a choppy, grinding stock market" next year.

At the other end of the world, the prospects are quite different. Abundant liquidity and expectations of a Fed rate cut pushed Hong Kong shares to new heights yesterday. Blue chips surged 3.9%, or 1181.68 points, to 31586.9, its third straight record close.

The market's advance was sharp enough to stir speculation of a correction, but some analysts say shares still have room to run. Francis Lun, general manager of Fulbright Securities, said the market could suffer a major selloff as early as November, though he predicted the benchmark Hang Seng Index might first soar as high as 35000. "The madness won't last too long," Mr. Lun said.

Money has been flooding into Asia, with a weak U.S. dollar prompting traders to seek investments across the region. In India, shares soared to a record as the key stock index crossed 20000 for the first time during the day, propelled by foreign-fund buying. The Bombay Stock Exchange's 30-share Sensex closed up 734.5 points, or 3.8%, at 19977.67. There are few signs of any slowdown, and some observers warned that the government may now have to make further moves to stem the flow of hot money.

In the U.S., the worrisome news, along with $90-a-barrel oil, so far has done little to push down the Dow industrials and the Standard & Poor's 500-stock index. Last week, the Dow had its best week in more than a month, rising 2.1% to 13806.7. It would need to rise only an additional 2.6% to surpass its record finish of 14164.53, hit Oct. 9.

Bullish investors point to low interest rates, which are fueling the world economy with lots of cash, and to the expectation that the Fed will cut interest rates following its meeting today and tomorrow. Some even see the weak U.S. economy as a positive factor for financial markets because it could force the Fed to cut rates by a half percentage point to 4.25%.

"The Federal Reserve is highly sensitive to this issue of credit getting squeezed in U.S. markets. If they see that happening, they will cut rates pretty aggressively," making it cheaper for banks, consumers and companies to obtain money and keeping the economy out of recession, says Rafi Zaman, head of U.S. stock investment at DuPont Capital Management in Delaware, which manages $15 billion in stocks.

Mr. Zaman is sticking with his holdings not only in the U.S. but also in such developing countries as Brazil and South Africa. Nonetheless, he says, a number of stock markets in developing countries, such as China and India, are starting to look like bubbles that could end badly.

"It is like being in the U.S. markets back in late 1998," he says. Professional investors then were almost forced to invest in bubble stocks, he says, for fear of trailing the competition, and the same is true today of some non-U.S. markets. He and others are prepared to start selling developing-country stocks at the first sign that the bubble may be getting ready to burst.
That is one reason to be wary of the view that the Fed will rescue the U.S. stock market. If global markets begin to teeter, and if U.S. consumers continue to struggle, rate cuts alone could have trouble holding the U.S. market up.

Few money managers consider this scenario imminent, as Mr. Zaman indicates. The warning signs are there, however. One stark way to see them is to compare the performance of the Russell 2000, an index of 2,000 smaller stocks, with that of the Dow industrials, the quintessential blue-chip index, made up of just 30 big stocks.

For most of the bull market that began five years ago, the Russell 2000 rose faster than the Dow, as its small, nimble companies benefited from low interest rates and a booming economy. Since Oct. 9, 2002, when the bull market began, the Russell is up 151%, while the Dow is up 89%.

Starting this past spring, however, they switched places. The Russell fell as consumer-spending growth finally began to suffer and as the housing crunch and troubled credit markets roiled the U.S. economy. The Dow industrials, dominated by multinationals that benefit from global sales, are up 1.3% since the end of May, while the Russell has fallen 3% over that period.

When a bull market is young, and the economy is vibrant, small stocks typically outpace large ones. When the bull market gets older -- five years is above average for a bull market -- and economic growth starts showing fatigue, the number of stocks that can sustain their gains tends to shrivel. The biggest, strongest multinationals keep rising, pushing up indexes such as the Dow. Finally, as the biggest stocks peak and decline, the bull market tends to end.

That isn't inevitable, of course. But there are other signs of below-the-surface weakness. Of the 500 stocks in the broad S&P 500, more than half were trading last week below their average levels of the past 200 days, says Phil Roth, chief technical market analyst at New York brokerage Miller Tabak. The overall index, buoyed by its biggest stocks, still was trading above its 200-day average. So while the index looked fine, most of its components didn't.

U.S. economic growth has slowed markedly in recent months because of the housing downturn, past Fed rate increases and a lingering credit crunch, with some banks still refusing loans to low-rated corporate borrowers and consumers. Oil futures have pushed above $90 a barrel, reawakening inflation fears. Faster inflation would push interest rates higher, making it harder to borrow money and taking away one of the main underpinnings of the economy and the financial markets -- cheap credit.

One big question now is whether the healthy job market and recent U.S. export strength, helped by growth in Asia and Europe and a weakening dollar -- which makes U.S. goods and services less expensive compared with foreign ones -- will offset those negatives.

Last week, stocks benefited from hopes that the Fed would bail out the market by cutting rates this week, which it almost certainly will do. But after that, the Fed won't meet again until Dec. 11. And in practical terms, it takes months for a Fed rate cut to percolate through the economy and actually boost corporate performance.

"I think the Fed is going to ease rates again. But as soon as the Fed eases, we won't have a Fed ease to look forward to, and we will be staring at the bad economic environment," says Mr. Roth of Miller Tabak.

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Aries Poon contributed to this article.