Two massive hurricanes just rocked the Gulf Coast. Oil and gas prices continue to soar. And Wall Street is entering its spookiest month, when dark memories of crashes past (October 1929 and 1987) are never far from mind.
So why are so many strategists cautiously bullish about the stock market?
Partly it's because, crashes aside, the fourth quarter is traditionally the best one for stocks. The Standard & Poor's 500-stock index gained 9 percent in the last three months of 2004, providing just about all of the year's gain. Partly it's because rebuilding from Katrina and Rita will pour billions into the economy, boosting shares in everything from cement makers to roofing companies. And partly it's because stock pickers anticipate the Fed is almost done raising interest rates.
In addition, strategists say, lots of big, quality companies are trading at attractive prices, and corporate profits, while slowing, are still at historic highs as a percentage of gross domestic product, a very bullish sign for stocks.
"I've been reasonably optimistic that we can get back to high single-digit growth in the stock market by year's end," said Kurt J. Wolfgruber, chief investment officer at OppenheimerFunds. "Valuations are such at this point that I don't really see a lot of downside risk."
But (and there is always a but these days, even with dedicated bulls) Wolfgruber cautioned that more severe energy price spikes, especially for natural gas, could drive consumers to retrench while slicing deeply into the profit margins of companies that have had a hard time raising prices to offset their higher costs. "This raises the risk that we could turn over into a consumer-led recession sometime next year," Wolfgruber said.
The Katrina and Rita Effect
The most immediate question on many investors' minds is about the impact of the twin hurricanes on the economy and the stock market.
Many investment managers say the impact will be muted because the economy is far too large and diversified to get knocked severely off course by even major natural disasters. Standard & Poor's chief economist, David Wyss, said he anticipates the storms will take at most three-fourths of a percentage point off economic growth this year.
And some of that decline will get reversed as money flows into the rebuilding effort. Raw materials such as cement are at a particular premium. U.S.-traded shares of Mexico-based cement maker Cemex SA have risen 18 percent since Katrina and Rita slammed the Gulf Coast in brutal succession.
This is in part because there is little excess cement supply in the United States, and some investors think trade tariffs on Mexican cement may be lifted to help with the recovery effort. Shares in Beacon Roofing Supply Inc., meanwhile, are up 15.6 percent since Katrina. Mobile home maker Fleetwood Enterprises Inc.'s stock is up 38.8 percent.
While there is undoubtedly money to be made in the business of post-disaster stock picking (think of defense contractors and security companies after 9/11), several money managers urged caution because plays that look good at first glance don't always pan out.
"It's such an isolated factor for most of the companies involved," said Jeffrey N. Kleintop, chief investment strategist for PNC Advisors. "It's not going to be a major factor for businesses. And the purse strings are going to be held by a central authority, so pricing is going to be pressured. And the federal government is often very slow in paying out on contracts."
Perhaps surprisingly, analysts say insurance companies may ultimately benefit from the storms because they will be able to raise rates significantly next year for policyholders in high-risk areas. Also, most primary insurance companies, as well as the giant reinsurers who pay out following big disasters, have plenty of cash on hand to make payments. And industry experts say insurance companies that need more capital will have no problem raising it from investors.
Patrick S. Kaser of Brandywine Asset Management Inc. said American International Group Inc. is among the best insurance firms at taking advantage when there is an opportunity to raise rates. "Their philosophy is to write as much business as possible when rates are favorable. They are great at playing the cycle," Kaser said. AIG shares are up 4.5 percent since Katrina hit. Brandywine owned 719,392 AIG shares as of June, according to data from Bloomberg.
Kaser said possible lawsuits and difficulty in assessing damage along the Gulf make it too soon to say how primary property insurers such as Allstate Corp. will fare.
Most of the market's gains this year, as evidenced by third-quarter mutual fund performance, have come from energy and natural resource stocks. Now the question is, will these shares continue to soar or have they peaked?
There is no easy answer to this question. In part, it depends on how cold the winter is and what impact temperatures have on the demand for natural gas, which most people in colder states use to heat their homes. A bad winter could mean big profits for natural gas producers such as EnCana Corp., whose shares are already up 30.4 percent since Katrina. But shockingly high natural gas bills this winter, which are a real possibility, could also help tip the economy into recession, experts say.
Several money managers said that barring any new shocks, crude oil should settle into a trading range below its current level, meaning now would be a good time to take some profit by selling shares in big oil companies or in energy-focused mutual funds.
In addition, big energy and energy-service companies such as Exxon Mobil Corp., Chevron Corp. and Halliburton Co. now make up about 9 percent of the S&P 500, which means anyone who owns an S&P index fund already has exposure to the sector.
"I predicate my forecast on history," said Jack Ablin, chief investment officer at Harris Private Bank in Chicago. "You can't have one sector grow to the sky and never come back to earth. Energy will come back to earth. We would prefer to own international stocks and emerging markets right now."
Indeed, international stock mutual funds and exchange-traded funds continue to be very hot, and several money managers said they do not expect that to change in the near future. The money managers suggested that in addition to emerging markets such as India and China, mutual funds that invest in Japan are attractive as that country continues to press forward with substantial economic reform and shakes off its long malaise.
Perhaps the biggest concern facing the markets in the fourth quarter will be the impact of higher energy prices on overall consumer spending. David R. Kotok, chairman and chief investment officer at Cumberland Advisors Inc. in Vineland, N.J., estimates that as of early last year, about 4.5 percent of consumers' disposable personal income went to energy products. In the second quarter of this year, he said, the proportion went to 5.5 percent, and he thinks energy now represents 6 to 6.5 percent of disposable personal income.
"The last time we had an abrupt shift of that magnitude was in the early 1970s," Kotok said. An extremely cold winter could make things even worse. "I think consumption is really under pressure, including all aspects of consumer goods, except perhaps staples" such as basic food and clothing. Kotok, who is not among the market bulls, said he expects economic growth of 2 percent or lower in the fourth quarter and thinks that recession is a real possibility.
Other strategists suggest the impact of high energy prices falls disproportionately on lower-income consumers, while the wealthy continue to have plenty of excess money to spend. That means higher-end retailers such as Nordstrom Inc. and Neiman Marcus Group could do well while lower-end stores such as those of Wal-Mart Stores Inc. and Dollar General Corp. suffer.
The same theory applies to publicly traded restaurant chains, with more-expensive eateries such as McCormick & Schmick's Seafood and Ruth's Chris Steak House faring better than mid-range destinations such as Outback Steakhouse. "When you look at demographics and the magnitude of the impact of higher energy prices, it is really onerous at the lower and intermediate end" of the consumer spectrum, said Wolfgruber of OppenheimerFunds.
Banks' Iffy Outlook
Money managers also say that big banks such as Citigroup Inc. are getting more attractive now that the yield curve, which is the difference between short-term and long-term interest rates, has shown some signs of getting steeper in the wake of Katrina and Rita. A higher yield curve means banks can borrow at lower rates and lend at higher rates, adding to their bottom line. Citigroup shares are up 5.6 percent since Katrina.
Still, the Fed's latest signal that it will continue to nudge up short-term rates has stemmed some of the yield-curve increase, pushing up short rates while the rate on the 10-year Treasury note remains steady. In addition, heavy recycling of foreign oil profits into long-term U.S. Treasury bonds could help keep long-term rates low, according to analysts.
While the outlook for big retail banks remains cloudy, many money managers are bullish on Wall Street's biggest investment banks, including Goldman Sachs Group and Lehman Brothers Inc., both of which recently reported blockbuster earnings on an uptick in merger and acquisition activity and healthy stock, bond and commodity trading. Goldman's pledge to buy back 60 million more of its own shares has also boosted the company's stock, which is up 10.8 percent since Katrina, closing Friday at $121.58.
Meanwhile, even those who are modestly bullish on the chances for a fourth-quarter stock market rally are not terribly sanguine about 2006. Several said they are looking for a year much like this one, in which stocks grind along with modest returns or even fall slightly as corporate profits slow further and higher interest rates impede rapid economic growth. Things could be even worse if housing prices drop, leaving highly leveraged homeowners feeling pinched.
"If we see slowing housing growth and consumer retrenchment, it could have a serious impact on corporate earnings," said Ablin of Harris Private Bank. "We might take some equity money off the table next year."