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Long view: The best of times, the worst of times

Ron Brounes

28 July 2006

Ron Brounes tells a tale of two markets in his summary of the 2006 so far. Ron Brounes is a certified public accountant and president of Brounes & Associates, a financial education, communications and strategic planning firm based in Houston, Texas.

"It was the best of times; it was the worst of times." Noted economist Charles Dickens would have been proud of 2006's first half. It has, after all, been a tale of two markets: one confident and hard-charging; the other timid, lost-seeming and weak. As a result, 2006 has so far proved interesting - "interesting" in the sense of "confusing," "off-putting" and decidedly "challenging" for many investors.

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It didn't start out that way, however. In the first quarter and beyond, well into April, equities across several sectors and capitalizations performed like gangbusters. Analysts began predicting new highs for many indexes and a return to the bull-market mentality that had been gone since the turn of the decade, century, and millennium. International and small-cap stocks led the way as investor confidence resurfaced.

The economy, as measured by gross domestic product (GDP), appeared strong with no end in sight. In another apparent sign of strength, rumors of merger and acquisition deals began to top the daily business headlines, bringing back memories of those high-flying days when big companies and private equity firms were ripe with cash and looking to invest. Earnings results were quite favorable in the early part of the year - even those "down on their luck" techs began to create enthusiasm as analysts opined that businesses and consumers would soon be upgrading older systems. In April, the Nasdaq hit its highest level in five years. As recently as 10 May 2006, the Dow Jones Industrial average climbed to within 80 points of its all-time high.

Enter Ben Bernanke. "It's worrisome that people look at me as dovish and not necessarily an aggressive inflation fighter."

Nice beard

The economist chosen to replace "the man, the myth, the legend" known by the world simply as Greenspan (like Madonna and Prince, only one name is needed) found that an impressive academic background and a nicely groomed beard alone don't bring credibility. A few loose-lipped remarks in front of the wrong audiences (mainly the business press) and Bernanke (and his Federal Reserve cohorts) found his first few months in office to be anything but a honeymoon.

Attempting to be viewed as a strong inflation hawk, Bernanke's comments instead sent shock waves through the markets as investors feared that future price pressures would keep the Fed raising interest rates indefinitely.

Of course, as the perception goes...1) higher rates serve... 2) to slow down the economy which... 3) could lead to reduced corporate profits and... 4) ultimately much lower stock prices.

Fear, panic, and the herd mentality set in as investors began to sell (aggressively in some cases) equities. In May the Dow, the S&P 500, and the Nasdaq lost ground, with many key international markets following suit. Suddenly techs and small-caps were no longer the places to be as investors sought the safe-haven of more defensive plays.

As the second quarter came to a close, investors remained uncertain about the next moves for the markets. Bonds reaped short-term benefits from the stock market pullback with the yield on the 10-year treasury briefly falling below 5%. Bargain hunters appeared in later June and gravitated more to large-cap equity issues. The flat yield curve implied that the next major move in rates would be lower (bullish for bonds), though the Fed lifted rates again on 29 June. Oil prices remained near all-time highs as turmoil persisted across the globe. With threats of another devastating hurricane season, investors simply couldn't get passed their fear of inflation.

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By and large, the domestic economy seemed to be fairing far better than those pundits at the Fed had implied. In the 1st quarter of 2006 GDP soared by 5.3%, its strongest showing since the 4th quarter of 2003. Though economists were convinced there might be a slight come-down from these favorable levels, most of them were upbeat about the longer-term prospects. After all, unemployment sat at 4.6%, the lowest rate in five years. Manufacturing releases revealed ongoing strength. Even certain housing stats (primarily new home sales and starts) showed surprising activity for a sector that many, including Greenspan, had written off a while back. And consumers continued to be primary catalysts for the economic growth as their confidence levels reached four-year highs in April.

Chicken Little

But then a few (not so) carefully placed comments by the powers-that-be at the Fed, changed the perception of the economy virtually overnight. One day the Fed was nearing the end of its current tightening cycle; the next day inflation was running wild and the rate hikes would continue indefinitely. Besides Bernanke, Fedsters Poole, Moskow, Guynn, Bies, and Kohn each felt the need to throw in his "Chicken Little" two cents about inflation and suddenly the "sky was falling" on the economy, markets, dollar, commodities, everything.

Clearly, the messages implied that inflation had become public enemy number one and the Fed would be steadfast in its mission to control prices regardless of the consequences. Some economists began speculating about the worst case scenario: a slow economy with rising inflation.

In reality, the economy is not quite as strong as the first-quarter GDP had implied and inflation isn't nearly as worrisome as Fed officials keep saying; not yet anyway. Just take a closer look at the numbers. Labor markets remain tight, but the most recent non-farm job additions were lower than anticipated. Some housing numbers have been surprisingly strong, but existing home sales have been declining along with median prices. Manufacturing releases indicate expansion, but the pace of growth has slowed. Consumers have exhibited confidence, but retail activity has weakened and the near-term outlook is sketchy at best. Energy prices seem likely to remain high for the foreseeable future, core inflation releases (excluding food and energy) still seem manageable. And Fed officials are sounding less alarming these days.

Moving forward, most economists expect the Fed to raise rates again in August and to keep an eye on inflation (and geopolitical developments) thereafter. If all goes well, that increase may be the last one for a few months.

Then again, "Chicken Little" may be just a Bernanke speech away. -FWR