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[TTHQ Staff]

BEING STREET SMART
___________________

Sy Harding

THE MARKET IS BETWEEN A ROCK AND A HARD PLACE!
August 5, 2005.


The news on the economy and corporate earnings could hardly be better than it has been over the last three weeks. The majority of companies reported 2nd quarter earnings that were better than Wall Street estimates. Factory orders and manufacturing activity picked up. Business inventories declined, indicating manufacturing production will also have to pick up to restock shelves. Home sales continued to climb to higher records. Auto sales blew away estimates. Boeing booked more orders for new commercial aircraft than had been forecast. The list of good news seemed endless. China even finally caved in and removed the peg of its currency to the U.S. dollar. Granted it was only a token 2.1% revaluation of its currency, but it was at least a step in the right direction.

On Friday, strong economic numbers continued to pour in, with the Labor Department reporting that 207,000 new jobs were created in July, ten percent more than the 180,000 economists had forecast. Average hourly earnings rose six cents to $16.13 an hour, the biggest monthly gain in a year.

Most of the time such good news would send the already rallying stock market surging still higher. Instead the market stalled right where it was three weeks ago, when the Dow closed at 10,640. It has been flat to down since, closing at 10,558 this week. The S&P 500 was at 1227 three weeks ago, and is still at that level, closing this week at 1226. Only the Nasdaq has moved higher, and it is just 1% higher than it was three weeks ago.

What is the market’s problem with the good news?

Strong economic numbers might encourage the Federal Reserve to continue raising interest rates to higher levels than had previously been expected, as it wouldn’t have to worry that it’s slowing the economy too much. When the Fed began raising rates in June of last year, the Fed Funds Rate was at a record low 1%. At the time the consensus estimate was that the Fed might slowly raise the rate over a period of time until it reached 2.5%. Instead, it has raised the rate nine times, until it is currently at 3.25%, and will surely be raising it to 3.5% at its FOMC meeting this month.

Of course as the Fed kept raising rates, and promising more to come, analysts kept pushing their forecasts up, so that recently the consensus had been that the Fed would stop at 3.75%. But now, with the stronger economic numbers, the consensus has become that the Fed won’t stop raising rates until early next year, and with the Fed Funds rate at 4.25%, maybe 4.5%.

However, even that forecast may be too low.

In my June 12 column, I opined that analysts were being too optimistic, that over the last fifteen years the Fed Funds rate has averaged 5.25%, and in its rate hiking cycles during that period the Fed did not stop hiking rates until the rate was at least 5.5%. That seemed to be the magic number that satisfied the Fed each time that it had raised rates enough to cool off the economy and ward off inflation. It is looking more and more like that may be the case again in this cycle.

In any event, the strong economic numbers of recent weeks, and even the new consensus, that the Fed will not stop until the Fed Fund Rate reaches 4.25%, has been enough to spook the bond market, which has now been down for four weeks in a row. And the stock market is not liking it much either that the higher short-term rates are finally having the effect the Fed was after. That is, the higher short-term rates are finally beginning to effect long-term rates. Not only has the yield on the long-bond begun to rise (driving bond prices down), but mortgage rates, which had been falling further even though the Fed was raising short-term rates, have finally begun to rise.

It was reported this week that the average 30-year mortgage rate has risen to 5.82%. When the Fed began raising rates last year, real estate experts were saying higher mortgage rates probably wouldn’t affect the real estate market unless they got above 6%. They are getting closer and closer.

So part of the stock market’s worry the last few weeks has probably been that if the stronger economic numbers encourage the Fed to raise short-term rates higher than was previously expected, it might just prick the bubble in the real estate market. And the real estate sector has been one of the two main supports under the economy and therefore under the stock market. The other support has been consumer spending, which is also not helped by higher interest rates.

It does leave the stock market between the proverbial rock and a hard place. It may want weaker economic numbers so the Fed will ease up on raising interest rates, but a slowing economy would not be good news for corporate sales and earnings, and so would not be good for the stock market.

It does have me still expecting the stock market will see a significant low for the year in the October/November time frame.



Sy Harding is president of Asset Management Research Corp., DeLand, FL, publisher of The Street Smart Report Online at www.streetsmartreport.com and author of 1999’s Riding The Bear – How To Prosper In the Coming Bear Market.