The Long, Slow Climb
Gains in First Quarter of 2006 Push Stocks Out of Doldrums and Into a 'Sweet Spot'

By Brooke A. Masters
Washington Post Staff Writer
Saturday, April 1, 2006

NEW YORK, March 31 -- Six years after the major U.S. stock market indexes reached all-time highs, only to fall back later with a sickening thud, the stock market is ever so slowly climbing back toward those peaks.

Nearly every week last month, the Dow Jones industrial average, the Standard & Poor's 500-stock index and the Nasdaq composite index set three-, four- or five-year highs. For the quarter that ended Friday, the Dow and S&P 500 were each up more than 3 percent, while the Nasdaq was up more than 6 percent.

Many market analysts are optimistic that the gains will continue. Valuations -- the ratio of companies' stock prices to annual earnings -- are lower than they were at the height of the 1990s bubble, and many companies posted strong earnings for 2005 and are predicting growth will continue. Others, however, warned that investors remain jittery over a softening housing market and the potential for disruptions in energy supplies.

Many stocks remain below their 2000 peaks -- the Dow Jones industrial average, for example, closed at 11,109.32 on Friday, up 391.82 for the quarter but well below its all-time high of 11,722.98. The S&P 500 closed at 1294.83, up 46.54 for the quarter, and the Nasdaq finished at 2339.79, up 134.47 since January 1.

"The economy's kind of in a sweet spot: There's relatively strong growth and a lack of inflation," said Andrew M. Brooks, head of equity trading for T. Rowe Price. "Everything's kind of in alignment and humming along."

Warmer-than-usual weather in January helped blunt the effect of high energy prices for both consumers and businesses and led to a one-third reduction in natural gas prices. The housing market appears to have plateaued and begun to cool without crashing, despite fears of a major real estate bubble.

"A lot of the headwinds that faced this market have dissipated. . . . It's a stealth bull market," said Arthur Hogan, chief market analyst for Jefferies & Co., who predicts the major indexes could add another 5 percent or more by the end of 2006.

Bill Wallace, a senior economist and market strategist with Columbia Management Group Inc., was equally optimistic, noting that on average, S&P 500 companies are trading at 15 to 16 times operating earnings, not far from the historical average of 14.5. "It's not a cheap market, but it's a reasonable market," he said. "We have average market valuation and above-average earnings growth."

The analysts cautioned that there are some storm clouds on the horizon. Another major disruption in the Middle East could cause more lasting energy price increases, the November congressional elections could lead to significant changes in tax and spending policies, or the economy could overheat and inflation could begin to shoot up. The economy is also far more dependent on housing than it has been in the past, and a slide in real estate prices could have a broad impact.

As a result, investors are nervous and tend to overreact to daily economic data that hint of inflation. "On days where you've seen exceptionally robust data, there's been a sell-off," said Jack Caffrey, an equity strategist for the J.P. Morgan Private Bank. "We've had better days with good, but not great, data."

On Tuesday, the Federal Reserve Board sparked an immediate sell-off when it raised interest rates for the 15th consecutive time and hinted that it might impose another increase when it meets again in May. The reaction from investors hinted at the jitters affecting many trading floors. "We may have gotten our rally and will perhaps move sideways" for the rest of the year, Caffrey said.

History also suggests that stock prices could become much more volatile, even if their overall trend remains upward.

"We haven't had a 10 percent pullback for more than four years, and they normally occur every 19 months or so," said Bob Doll, president and chief investment officer for Merrill Lynch Investment Managers. "The market is acting tired." He said analysts have already reduced overall earnings growth estimates for 2006 from 13 percent in January to 10 percent now. "We think that number will end up at 7 percent" by the end of the year, Doll said. But even Doll is not predicting a recession or suggesting that investors pull out of equities. Rather, he said, a pullback might be "the pause that refreshes."

The rising stock market has floated most boats -- large-, medium- and small-capitalization stock indexes have all seen increases of more than 4 percent this quarter. But some sectors clearly did better than others. The telecommunications companies that are part of the S&P 500 have risen about 14 percent since January 1, while prices of utility stocks in the same index fell slightly. "After three years of underperforming expectations, [telecom] was an overlooked sector," Caffrey said. When investors realized that prices to consumers were not falling as fast as they had been and that the sector might therefore have good cash flow, they jumped right in, he said.

The big winners this quarter include Ciena Corp. of Linthicum, Caterpillar Inc. and Walt Disney Co., while big losers included Amazon.com, Intel Corp. and Tyson Foods Inc.

Indexes

New York Stock Exchange composite index fell 38.59, to 8233.20.

American Stock Exchange index fell 13.92, to 1935.99.

Russell 2000 index of smaller-company stocks rose 2.55, to 765.14.

Volume

NYSE: 2.30 billion shares, down from 2.33 billion on Thursday. Advancers outnumbered decliners 10 to 9.

Nasdaq: 1.91 billion shares, down from 2.18 billion. Advancers outnumbered decliners 8 to 5.

Commodities

Crude oil for May delivery: $66.63, down 52 cents.

Gold for current delivery: $581.80 a troy ounce, down from $586.70 on Thursday.