Markets: What Should Investors Do?
New York: April 25, 2005
By John R. Stephenson

What a roller coaster week it has been with the markets swinging violently down and then back up again. Is it safe to go back into the market? Or should investors stay close to shore? Are high oil prices about to put a damper on the economy or is this just a blip in the road? Will the dollar tank and send equity markets for a tumble? Will the latest round of anti-Japanese demonstrations in China further upset investors? Is there a clear direction for markets in the future or are investors to remain bipolar in their investment approach?

There are no shortages of candidates to blame for the periodic market corrections that we have witnessed in 2005. Some of the favorites include the price of oil, interest rates, slowing corporate earnings, the decline of the U.S. dollar and the rise of geopolitical and trade tensions around the globe. While many concerns can be raised, just what problems should investors focus on?

Rising interest rates, no doubt, pose a significant threat to investors. For starters, they make fixed income investments less attractive as bond yields rise (the price of bonds falls), not to mention the fact that higher interest rates tend to compress stock market valuations. With inflation on the move and a more active Federal Reserve, can worries about inflation and higher interest rates be far behind? Such fears may be a little overdone since bond yields over the last few weeks are falling rather than rising. The basis for inflation fears - primarily rising labor costs - seem to be constrained by slack labor markets around the globe.

A weaker dollar is generally a bad thing for equity markets. But yet the much-anticipated sell-off in the U.S. dollar has yet to occur. In fact, the dollar has rallied in recent weeks confusing the experts and sending commodity prices lower. While the combination of the eye popping U.S. government deficit and balance of trade deficit will likely drag the dollar lower, investors may have to wait a little while yet before the dollar begins to falter.

While corporate earnings have been strong for some time (with earnings growth rates in the 20% range), it is unlikely that this can be sustained. Slowing earnings growth is not necessarily a death knell for the equity markets as equities have faired reasonably well in markets with much more sustainable levels of earnings growth. Over the past 55 years, the average growth rate in corporate earnings has been 7.23% and sustained declines in earnings growth have been few and far between. While corporate earnings growth rates are likely to level off in the 8% range, this is certainly in keeping with historical norms in the stock market and not a huge concern for investors.

Figure 1: Frequency of Earnings Growth 1949-2004

Source: Smith Barney

But yet things are not quite right. The world economy remains in a serious disequilibrium with the global engine of growth remaining the overstretched U.S. consumer. With no other major consumers in sight, the world seems fixated on propping up the consumption machine that is the U.S. consumer.

Add to these problems the possibility of a major economic shock in the form of rapidly escalating energy prices and you have the recipe for a global economic meltdown. With dwindling energy supplies, coupled with strong demand for oil, can this day be far away? These concerns are even further heightened as the world and the gas guzzling United States (25% of global oil demand) lurch toward the summer driving season.

European unity may also be a concern as France edges towards a "no" vote on the 29 th of May on the passage of the new European constitution. Trying to impose centralized monetary policy on a series of disparate nations who have no national imperative to comply is the problem that has hamstrung growth and progress in Europe for some time. This further highlights the most basic contradiction of the European union - that politics and economics do not mix. While remote, the possibility of an outbreak of overt hostility between China and Japan further underscores the precarious balancing act that the world economy is now facing. All the while, the United States becomes even more protectionist with China bashing the norm on Capitol Hill.

Protectionism, threats to European unity and possible hostilities on the world stage combined with slowing corporate earnings and rising interest rates augur caution rather than conviction. Investors would be well advised to avoid banking, technology and other sectors where there has been far too much enthusiasm and too little profits. While we may very well muddle through the next few years, it is probably more important than ever for investors to play good defense rather than try and ride the wave in a seemingly directionless stock market.