Stocks Begin 2006 on a Hot Streak

NEW YORK -- At first blush, the first quarter of 2006 was a crowd pleaser.

The Standard & Poor's 500-stock index, which represents large companies, was up 3.7 percent. The Russell 2000 index, which tracks stocks of small firms, rose 13.9 percent.

"Everybody should be happy -- large cap, mid cap, small cap, domestic, international, even real estate went up. The trend is still your friend," said Sam Stovall, chief investment strategist for Standard & Poor's. S&P's composite index for real estate investment trust stocks rose 9.5 percent.

Energy, industrial and materials stocks did particularly well. The latter two sectors tend to rise and fall with the general business cycle and may reflect some investors' views that the economy is still growing.

But there were disturbing signals in the overall rosy results: Most of the quarter's gains came in January, and the precious metals sector was up sharply while utilities were down, suggesting that investors are concerned about inflation and rising interest rates.

As a result, even bullish analysts doubt that equities can keep up this fervid pace. "It's going to be a very challenging and volatile year," said Joe McAlinden, chief global strategist for Morgan Stanley Investment Management. "I think the market's going to have an explosive upward move in the first two to three quarters followed by an implosive downward move."

Stovall agreed that the third quarter could be a rough one: The S&P has hit a four-year low in every midterm congressional election year since 1962, with the exception of 1986 when Reagan administration tax cuts may have changed the dynamic. (That four-year low occurred in 1987.) The third quarter also coincides with the potential for high energy prices because it includes the peak driving season, and hurricanes have the potential to disrupt supplies.

Not surprisingly, oil and oil-service stocks have been doing well, suggesting that investors think energy prices will stay high. The Oil Service Sector Index gained 14.4 percent for the quarter, led by Global Industries Ltd., which was up 27 percent. The Amex oil index rose 8.5 percent. The biggest winner was Marathon Oil Corp. of Houston. Exxon Mobil Corp. was in the middle of the pack, rising 8.4 percent.

Gold stocks were also among the hottest of the hot. The Philadelphia Stock Exchange's gold and silver index rose 10.6 percent for the quarter. Gold futures then went on to hit a 25-year high on Thursday, topping $600 an ounce. McAlinden called the rising gold prices "an early warning sign . . . the fact that gold is up and inflation readings are still low is to me saying that the barometer has dropped, but the skies are still blue. A storm is gathering."

By contrast, utilities and financial services did relatively poorly. "If there's inflation, those two sectors tend to suffer more because they are more interest-rate dependent," Jeff Tjornehoj, senior analyst for the Lipper research firm, said. Utilities carry a lot of debt, and inflation makes it harder for banks and other lenders to make money on interest rate spreads, he said.

The Dow Jones Utility Index lost 4percent in the quarter, and shares sank at 12 of its 15 member companies. The biggest losers included Dominion Resources Inc. of Richmond and TXU Corp., which each lost more than 10 percent, while AES Corp. of Arlington was one of the few bright spots, gaining 7.8 percent. The financial services sector within the S&P did better than utilities but lagged behind the rest of the index, gaining 2.6 percent.

The technology sector, as always, was volatile. The information-technology sector of the S&P 500 grew at an overall rate of 4 percent. But the sector also included some of the quarter's biggest losers -- Intel Corp. and Amazon.com Inc., each down more than 22 percent for the quarter. The Internet software and services firms within the S&P 500 dropped 18.7 percent.