Fed's green light to markets and economy likely postponed by geopolitics. Gordon Fowler Jr. is CIO of Glenmede Trust Company, an independent wealth advisory based in Philadelphia.

Summary The world's equity markets declined last week as a result of the conflicts in the Middle East. Shocks to the markets caused by geopolitical events generally are followed by rallies. Looking at the number of stocks that are trading below their 50-day moving average price seems to indicate that the market may have overreacted and could bounce somewhat from here. The longer-term issue with the markets, however, is the degree of uncertainty as to when and how the Federal Reserve will bring inflation under control. The recent events in the Middle East reinforce the premium that has been built into oil prices, and potentially extend the time when the inflation issue can be resolved

Review and outlook

As the bombs fell in the Middle East last week, the world's equity markets felt the reverberations. Generally, geopolitical shocks to markets have translated into buying opportunities. Markets often awaken after they have fallen substantially, and demonstrate that the world's economies will keep on ticking - and in the process markets frequently bounce back with a healthy rally.

Unfortunately, there are a number of reasons why events in the Middle East may not be quite as transitory. And what's going on there seems to exacerbate the market's principle economic problem: inflation. Uncertainty as to when the Federal Reserve will bring inflation under control is the principle reason why the market has been unable to move out of its trading range.

As measured by the S&P 500, the stock market declined by 2.3% last week. The sectors that endured the greatest declines included technology (down 4.7%), consumer discretionary ( down 4.5%) and industrials (down 3.7%). Small-capitalization stocks took it on the chin, declining by 3.9%. Not surprisingly since oil prices topped $78 a barrel, energy stocks performed well rising by 2.5%.

International equities, as measured by the EAFE index, also posted poor returns, falling 4.5%, hit by local-market declines and a stronger U.S. dollar.

This decline was precipitated by a conflict between Israel and Hezbollah in Lebanon. Typically, geopolitical events cause a fair amount of angst but have very little lasting effect on the markets. As I said, a rebound often follows a sharp sell off.

Grounds for a rebound

There is something to be said for the argument that market is in fact poised for a rebound. One way to tell if a market is oversold is to measure the percentage of stocks that are trading above or below their respective 50-day or 200-day moving average prices. When only a small percentage of stocks - less than 30%, say - are trading above their moving average price then the market becomes "oversold" and subsequently tends to reverse course. The duration and magnitude of a rebound is a function of whether the stocks are trading below the 50-day or 200-day moving average. If less than 30% of the market's stocks are trading above their 50-day moving average, then a bounce back tends to happen quickly and with limited magnitude. When less than 30% of the stocks in the market are trading above their 200-day moving average, we tend to be treated with a more sustained and substantial rally.

As a result of the latest shock, approximately 23.3% of stocks in the market are trading above their 50-day moving average while 39.9% of stocks are trading above their 200-day moving average. If historical patterns repeat, we would assume that the market will have a short and sharp rebound off of recent closing prices. A sustained rally is less assured.

|image1| New worries, same problem

A rebound from current oversold levels seems rational. However, it is uncertain whether the rebound will have much to do with the events that generally cause a rally after geopolitical events. Policy makers quite often react to negative news by putting in place stimulus packages that help pick up the economy after it has been knocked down by the shock.

For example, the Fed reacted to 9/11 by cutting interest rates and the U.S. government loosened its pocket book and funded New York City's recovery. Similarly, the government wrote some big checks to offset losses caused by Katrina. The fact is, the loss of wealth due to acts of God and terrorist attacks don't necessarily lower a country's gross domestic product (GDP) and writing checks and lowering interest rates can result in a fairly quick boost to the economy.

The problem is that such spending wouldn't be advisable right now. Though spending has been out of control for the last few years, good progress has been made on the federal budget deficit. With the exception of the late 1990's, the Federal deficit has generally not improved much beyond 2% of GDP. But that's still too much given the fiscal demands that could arise when the baby boomers retire.

|image2| The Fed has still not slain the inflation dragon. Rate cuts or even a cessation in increases should only really come when inflation expectations have begun to reverse course. In fact the indicators of inflation are at best mixed. Recent weakness in the housing markets would seem to indicate that the U.S. economy is slowing, which allows for some decline in pricing pressures.

On the other hand, Gold prices have since risen steadily after declining several weeks ago. The rise has been prompted by the Feds "dovish" comments on inflation (and only recently augmented by geopolitical uncertainties). Other economic indicators like industrial production have shown some strength.

In fact, the grating aspect of the latest Middle East conflict and the associated rise in oil prices is that it adds to the water-torture aspect of this economic environment, leaving us to wait - drip (pause), drip - for news, specifically from the Fed, to the effect that inflation is under control.

To make matters worse, there has been an unfortunate shift in recent years in the power structure in oil producing countries. The nice thing about OPEC and other leading oil producing countries over the past twenty years is that it has been dominated by countries that were motivated more by greed than lust for power. Greedy countries have to balance their desire to make money with the desire to keep the world economic system that pays the bills in place. It's not quite as clear that some of the larger players among oil producers including the Iranians, Venezuela's Chavez and even perhaps our buddy Putin of Russia wouldn't be the least bit bothered by a little economic hardship for the West.

Fortunately, none of these bad actors has enough power actually to set a near-term price. What they can do, however, is misbehave enough to send prices up generally and so prolong the - drip (long pause) drip - water torture. But they do have the ability to make prices rise and add to the water torture. -FWR

Review and outlook is intended to be an unconstrained review of issues, topics and considerations of possible interest to Glenmede's clients and is not intended to be applicable to any one particular client. Actual investment decisions for particular clients are made in light of applicable considerations and may be different from the views expressed here. Likewise, actual portfolio performance may differ from the results discussed.

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