A horse blessed with what racetrack regulars call a “big kick” appears undistinguished for much of a race, then in the home stretch breaks out of the pack with a burst of speed. Through the first three quarters of 2005, many investors had been anticipating that the stock market, like a prized thoroughbred, would show a big kick. But now, what with hurricane damage, sky-high energy prices and the Federal Reserve’s unyielding program of interest-rate hikes aimed at countering growing inflation worries, is the long-awaited fourth-quarter rally turning into a long shot?
A lot hinges, experts say, on the third-quarter profit reports U.S. companies issue in the next few weeks.
“We’ve had a situation this year where corporate earnings have been growing at a double-digit rate and the market has gone nowhere,” notes Jim McDonald, director of equity research at Northern Trust.
Indeed, even though many companies’ profits have consistently strengthened, and consumers have remained willing to spend, stocks eroded slightly over the first half of the year and managed a nothing-special increase in the third quarter.
As a result, through the first nine months, the Dow slipped 2 percent, the Nasdaq composite index declined 1.1 percent, and the Standard & Poor’s 500 index managed a 1.4 percent gain.
Through it all, many people have been figuring the action would be in the fourth quarter, in the form of a solid if unspectacular equities rally.
It’s not a silly notion. For a variety of reasons, including the tendency of mutual funds to make certain tax-loss sales in September, the fourth quarter has frequently proven to be the strongest period of the year for stocks.
In fact, in 2004 the S&P 500 was down for the year as late as mid-October, before a sharp year-end rally sent the market up so smartly that the S&P ended the year with a 9 percent gain.
The near-term questions for investors include: How likely is a repeat of last year’s “Santa Claus rally”? And has it been pushed back, or eliminated, by recent developments?
At Northern Trust, McDonald says, “our expectation is the equity markets will move up gradually over the next three to six months, as corporate profits continue to show solid growth and investors grow comfortable that the Fed is nearing the end of its tightening cycle.”
Wall Street pays a lot of attention to price-to-earnings multiples. For example, if a steel company is expected to earn $5 a share over the next 12 months, and its stock is trading at $60 a share, people on the Street say it is trading at a multiple of 12.
But if the company’s profit picture brightens and it’s now expected to earn $6 a share, and the stock price remains at $60, then the multiple of the steelmaker’s stock has been “compressed” to 10, making it more attractive to investors.
That compression process has been taking place over the course of the first three quarters, and that is the logic behind the hoped-for rally.
But nothing comes easy. During the third quarter, Hurricane Katrina caused huge damage and crimped the nation’s already overstretched petroleum-refining capacity. And recently, amid mounting evidence that inflationary pressures are starting to move through the economy, a chorus of Fed officials has been signaling that interest-rate hikes are likely to continue for some time.
Although “the bears had all the ammunition needed to push the market into a tailspin last month,” A.G. Edwards market strategist Al Goldman recently observed, stocks haven’t tanked.
“The most critical factor that has kept the stock market afloat,” the market veteran said, “is the continued resilience of the economy.”
Despite the near-term drag caused by superhigh gasoline prices, the economy’s longer-term outlook remains positive, according to Goldman.
The second reason stocks have held up, he said, is because “stocks in general are not overpriced and thus not vulnerable to temporary shocks.”
Those conditions, he told investors, “argue for a moderately higher stock market for the rest of 2005.”
Still, a key question has yet to be answered, according to Alexander P. Paris of Barrington Research. Fewer corporations than normal have “preannounced” profit surprises in the weeks leading up to the earnings season that is about to begin, Paris said.
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That may mean, he speculated, that “many companies probably don’t yet know the full negative impact on their earnings from the hurricanes, the sharp spike in energy costs, the rise in other material costs and the higher dollar this year.”
The coming third-quarter earnings may well prove to be “less than expected,” Paris said.
Nonetheless, he said, there’s “still a good chance” stock prices will rise enough in the fourth quarter to yield a gain for the year.
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Editor’s note: Today’s report on 3rd-quarter mutual fund and stock performance takes the place of the Monday Business section.