Volatility takes center stage in stock market

July 24, 2006 09:20 AM

In this midterm presidential election year, one thing rings loud and clear for the stock market: The Federal Reserve is in the driver’s seat. In early May the stock market was humming along, but by midmonth the market lost almost all of its gains for the year in a matter of weeks. More corrections followed.

For months the market has gyrated around anticipated interest rate increases and actual rate hikes. Federal Reserve Chairman Ben Bernanke and the Fed moved forward with their inflation fighting campaign and raised the fed funds rate by 25-basis points to 5.25% on June 29, the 17th consecutive rate hike increase in two years. Stocks dived down more than 120 points the day before as investors bailed out ahead of the rate hike. While the phrase “the committee judges that some further tightening may be needed” was not present in the Fed’s remarks in June, the comment “the committee judges that some inflation risks remain” stayed.

“The Fed will probably raise rates two or more times,” said Stewart DeSoto, president of DeSoto Capital Management, the week before the June hike. “I expect to see the Fed funds rate go up to 6%,” adding that the Fed should not have indicated earlier in the year that it was nearly done with its rate tightening. Some analysts even openly blame the stock market’s recent weakness on this inconsistency from the Fed.

But while inflation still appeared to be on the mind of Bernanke and Fed policymakers in June, some analysts such as Marc Borghans, chief equity strategist with LaSalle Bank Wealth Management Group, are not very worried about inflation. Commenting on the long term state of inflation Borghans says, “Inflation is not a runaway problem. Chairman Bernanke has to establish his inflation fighting credibility. He needs to give the message that he is serious about this.” He adds that while the Fed says it is data dependent, when it comes to rate hike decisions, they seem to not be giving the same weight to data pointing to a slow down in the economy. “But in the end inflation will not be a big problem. You have to understand that inflation is a lagging indicator, not a leading indicator,” he says.

REAL ESTATE BUZZ

According to analysts and the Fed, the housing market will continue to be a major determining factor in where short term interest rates are headed, and as a result where the stock market is going. The National Association of Realtors reported that sales of previously owned homes in the United States fell in May to an annual rate of 6.67 million; the slowest in four months. Borghans says further proof of the market cooling can be found in the owners equivalent rent component of the CPI index. He explains that recently, as the housing market has faded, more people are renting and as a result rents are increasing. “The slightly positive rate of housing growth is fading quickly. It is slowing to a point of being virtually flat. In the coming months I see the rate of growth near flat and that we possibly could have a flat market for a few years.”

Mike Kimbarovsky, a principal of the fund of funds Advocate Asset Management, says even a slowdown in the housing market could spell trouble for the stock market. “The nature of the mortgage debt, coupled with [rising] unsold home inventory makes us pessimistic…The detrimental results can easily be realized if housing prices simply stopped rising with the same vigor as they have in the past,” states Advocate’s first quarter market commentary.

A cooling housing market is only part of Kimbarovsky’s concerns. His bearish outlook on the market stems from several factors, including that the “U.S. economy is living on borrowed time.” Kimbarovsky explains that both consumers and the government’s tendency to live in the moment will not bode well for stocks in the long run. America’s huge budget deficit, a rising trade deficit and consumers continuing to borrow variable debt serve as drivers for the market to go down. Advocate states that according to the Office of Federal Housing Enterprise Oversight, only 1.1% of mortgages were interest-only in 2000. By 2005, these interest-only mortgages accounted for 27% of all mortgages. “This is troubling considering the consumer has driven the GDP growth,” Kimbarovsky says, adding that by the end of the year he predicts we will see more delayed credit card payments and more foreclosures on mortgages.

The stock market also has to contend with the price of oil. “With interest rates continuing to climb and oil prices rising — we expect oil prices to reach their all-time high once again before the end of the year. These factors look ominous for the stock market,” says Mike Zarembski, futures analyst with Xpresstrade.com.

Borghans sees crude prices staying firm. “It is exhibiting more consolidating and I expect to see a move up later in the year [for crude oil],” he says.

Other analysts don’t see energy prices playing that large of a factor on equities. “Energy prices have been historically high for quite awhile. I don’t see this having a big effect [on the stock market] unless they get extremely high such as up to $100 a barrel,” DeSoto says.

HOW LOW CAN WE GO?

The market rarely reacts positively to factors such as rising interest rates and inflation fears, but just how much of a drag will we get from these stock market negatives? Bo Yoder, editor of 5MinuteInvestor.com, says after August the market could be in store for a fairly significant slowdown. “My internal bias is to be bearish. There tends to be a lot of selling pressure and not a lot that will bring buying. This tells me that the market wants to go lower,” he says. Zarembski agrees. He predicted in late June that if the S&P 500 broke 1269, which it did, the index could test the 1174 low. “This fall could be quite ugly.”

Borghans is also concerned. “We easily have not seen the lowest point of the year yet,” Borghans said in late June. “But hopefully by the end of the year we will be in plus situation. I am looking for a seasonally strong fourth quarter. I suspect we will see the S&P Index with a total return for the year of about 5% to 7%.” He adds that 2006 is a mid-term election year, which normally is the weakest of the four years.

DeSoto also looks for a traditional fourth quarter rebound to pull the market along. “If earnings stay strong and as soon as we reach the end of rate increases, the market will then be primed to have a good November and December rally in the traditional

timeframe,” DeSoto says. He expects the S&P 500 Index to be back up to the 1300 to 1350 range by about January 2007.

With many analysts handing out bearish forecasts, investors may be wondering what sectors, if any, they should look to. Yoder suggests avoiding the weakness in the indexes and picking stocks off the beaten path. “Look for out of the way names like Hershey or Sonic, a fast food chain; stocks that aren’t on the tips of people’s tongues. As marquee names underperform, investors will put their money in other stocks. There will be a huge herd mentality,” Yoder says. He explains that traders may want to be cautious of metals and basic materials. “Basically, stay away from anything that did well,” Yoder says. “I see an exit type rotation in oil and basic materials.”

Borghans points to high dividend stocks and utilities as possible opportunities. “If you have to be in equities this may be the space to go to,” he says. Borghans also says consumer staples and some healthcare sectors are other potentials.

For some investors, stocks may be too volatile, and with higher bond yields, investors may find more reasons to move their money from stocks to bonds. The 10-year Treasury note yield hit a four-year high of 5.24% on June 28. This may look attractive to investors who don’t have the stomach for this year’s stock market. “More and more money will move to fixed income late in the year,” Borghans says. He explains that a 5.25% Fed funds rate looks interesting, especially since the U.S. economy is starting to slow and the housing market is cooling. And Kimbarovsky comments, “Cash is a good strategic alternative now with 5% plus yield on cash.”

TAMING INSTABILITY

Futures traders have more tools than the average investor to deal with this volatility. But traders and analysts caution that everyone should be prepared for a long ride. “Expect dramatic volatility for the next 18 months,” says George Slezak, editor of CommitmentsofTraders.com and StockIndexTiming.com. Slezak has been in a sell signal since the beginning of the year, but explained in late June he was expecting to get a buy signal soon. “The rule of the day is that volatility is increasing,” Slezak says. “Traders should prepare for larger daily moves than what we saw last year. The days of low volatility are behind us for a couple years.”

Of course futures traders will look for profit taking opportunities even in markets that appear at first glance to be behaving badly. And those that have fought this battle before have some words of wisdom to follow. “Trade lightly, that is important,” Yoder says. “Some bullet points to remember in this type of trading environment include taking smaller time frames and waiting for the market to come to a radical extreme. Don’t take mediocre trades. A lot of patterns will show up that will be false.” He explains that in many cases markets will not have enough energy to allow trades to follow through and warns against overtrading. “Overtrading will be the main killer in this type of market,” Yoder says.

Stay with the “keep it simple” mentality Zarembski comments, “Be prepared to cut back on normal positions. If you trade five lots normally, trade one or two lots instead.” He also says traders should be prepared to have wider stops than normal. And Zarembski reminds us that yet another route to combat volatility is options. He says traders may want to consider options or options spreads, but reminds traders not to use too fancy of strategies in this type of market. “Go with the general trend,” Zarembski says. “Don’t pick bottoms or tops.”

Carla M. Bauch is a freelance writer in Chicago.

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