For Stocks, a Bummer Year Gets Brighter
By E.S. BROWNING
Staff Reporter of THE WALL STREET JOURNAL
November 20, 2005
This is typically the sweet spot of the year for stocks. The question is whether the 2005 version will feature real sugar or just Sweet'N Low.
With surprising frequency, the period from November through early January is the strongest for stocks, often providing the majority of the annual gain. So far, the pattern is repeating this year.
From January through October, the Dow Jones Industrial Average fell 3%. Since then, it is up 3%, leaving the Dow barely changed this year, off 0.2%. On Friday, the Dow rose 0.4%, producing a gain of 0.8% for the week. The Dow finished at an eight-month high. The Standard & Poor's 500-stock index and the Nasdaq Composite Index, up similar amounts on the day, hit 4½-year highs.
Why year's end is so good for stocks has long been a subject of debate. Some trace it to days when farmers withdrew money to finance a harvest in late summer, then deposited profits afterward. Others point out that many companies, not just retailers, do the bulk of their business and make their largest profits at year's end, as clients buy for the new year. Markets tend to rise ahead of expected January investment of retirement money in stocks. And crude-oil prices have a way of falling at year's end, after the summer driving season, easing inflation fears. That is happening now -- with crude oil down to a five-month low of $56.14 a barrel last week -- and also happened last year.
Awaiting Santa
Whatever the reason, a lot of money managers are counting on a 2005 year-end rally to save their portfolios from decline and leave them in the black, looking like heroes to clients. Little wonder that Wall Street calls the late-year stock surge a Santa Claus rally.
This year, however, the rally has been mild so far. Despite their recent recovery, stock indexes still show little change since the year began. Even as they wait for Santa, many investment pros are biting their nails.
"Call it wishful thinking or true belief, but most people out there think we have a little more upside to come," says Stephen Sachs, director of trading at mutual-fund group Rydex Investments in Rockville, Md.
He thinks the Dow Jones industrials could join the S&P 500 at a 4½-year high before the year ends, with the Dow moving back above 11000, a level it hasn't finished at since the attacks of Sept. 11, 2001. But that still will represent an annual gain well below 10% for each benchmark. And then, Mr. Sachs says, investors should brace themselves for a pullback early in the new year -- much as occurred this year, when the Dow Jones industrials fell 2.6% in the first quarter.
Why so glum? Several reasons, the most important being the Federal Reserve. With the economy still strong, with interest rates low and with corporate profits still rising faster than average, economists at the Federal Reserve (and at a lot of other places as well) fear that inflation will begin to rear its head unless the Fed keeps pushing interest rates higher.
Back in 2003, to get the economy going again after a painful recession, the Fed cut its target rate for overnight bank lending down to a 45-year low of 1%. It left the target there for a full year. With loans the cheapest they had been in many people's lifetimes, money flooded into financial markets, pushing up the prices of stocks, bonds and real estate.
Now, with the recession a distant memory, the Fed needs to sop up that excess money before that cash pushes up prices any more than it has. The Fed does this by pushing interest rates steadily higher.
Rate Anxiety
This month, the Fed nudged its target short-term rate back to 4%, and many on Wall Street expect the Fed to keep raising rates for months to come -- perhaps until the short-term rate is at 5% or higher.
"That seems to be a hot button right now -- inflation and where rates are going to reside for a while," says Tim Heekin, director of trading at San Francisco brokerage firm Thomas Weisel Partners.
Higher rates put pressure on consumers, who pay more for adjustable-rate mortgages and other loans, and on businesses, whose customers are pinched and which must pay more for their own borrowing. The fear of still higher rates is probably the main thing holding stock prices back now.
Investors are particularly anxious because, although banks' lending rates have moved steadily higher, the bond market hasn't yet responded much.
Trouble is, the bond market can't ignore the Fed rate increases forever. At some point, bond yields, too, will move up, and that will drive costs for consumers and businesses still higher, putting a second burden on corporate profits and stock values.
The real bulls think that the market's recent softness is just a pause before a strong stock rally. Something similar happened a decade ago. In 1994, rising interest rates kept stocks from showing much progress, but once rates began to fall again in 1995, stocks took off. But many investors are reluctant to bank on that happening again this time. In the mid-1990s, the Federal Reserve managed to end its interest-rate-raising campaign without driving the economy into recession. But too often, Fed rate increases have led to recession, or at least to a serious economic slowdown, which is what happened from 2000 through 2002. Investors fear another "hard landing" again now.
Giants Are Gaining
Partly reflecting those concerns, some of the leaders of the latest stock rally have been "mega-cap" stocks -- those of the biggest companies such as Microsoft (MSFT), Intel (INTC) and Wal-Mart Stores (WMT) -- which many view as the safest. Microsoft is up 9% so far this month. Intel is up nearly 8%. Wal-Mart is up almost 5% and Citigroup (C) is up nearly 6%.
Many investors are heartened that the gains aren't being led by a limited group of energy-related companies, but rather by a broader group of blue-chip stocks. Falling oil prices have put an end, at least for now, to the energy stocks' dominance, and broad leadership often is seen as a good thing.
But part of the reason professional investors are turning to big, liquid stocks is that they know their holdings will be easy to sell if they need to get out in a hurry. Until that kind of nervousness is alleviated, it could restrict stock gains. "With everything that has happened this year, the market has put in a creditable performance," says stock trader Michael Driscoll at New York brokerage firm Bear Stearns. "It keeps grinding its way higher and I think it will do that until the end of the year."
And after that? That's what has some of the pros nervous.
Write to E.S. Browning at jim.browning@wsj.com
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