Archive for Sunday, July 11, 2004

Signs show improving stock market

July 11, 2004

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How did investors do in the first half of the year? Well, there's not much to celebrate. Stocks fell far short of the smart gains they tallied in the first half of 2003. But at least the average investor hasn't lost money this year, as most did in the first half of '01 and '02.

And there are some promising signs for the second half of the year.

Total return for the Dow Jones industrial average was 0.8 percent in the first half. For the Standard & Poor's 500 it was 3.4 percent, for the Nasdaq Composite 2.4 percent. Total return assumes all dividends are reinvested.

Among the 6,712 diversified stock mutual funds tracked by Lipper, average gains were a mere 2.7 percent. The 2,661 long-term bond funds Lipper follows averaged paltry returns of 0.3 percent, as rising interest rates undercut bond prices.

Obviously, the lackluster performance reflects lots of worries. Many forecasters were surprised, for example, when the government Friday reported only 112,000 jobs were created in June, less than half what many had expected. About 235,000 were created in May.

Oil prices are high and inflation has ticked up enough to cause the Federal Reserve last week to begin nudging interest rates upward for the first time in four years.

Rising inflation and interest rates can hurt both stocks and bonds. And although the Fed said it expected to make additional rate increases at a slow pace, some economists believe the Fed has underestimated inflation and will have to raise rates faster.

Terrorism and the uncertain situation in Iraq continue to hang over the markets.

Polls showing President Bush and Sen. John Kerry in a close race raise questions about what economic policy will be come 2005.

But there is good news too. Many companies reported strong earnings gains during the first half, and most surveys show economists expect annual economic growth to pick up to a healthy rate above 4 percent.

Also, stocks are not as pricey as they were in some recent years, so they are less likely to fall. Standard & Poor's said last week that the price-to-earnings ratio for the 500 stocks in the S&P 500 averaged 18.8 on June 30. That compares to an average of 29.1 since 1996 and 23.6 since 1988.

The P/E ratio is figured by dividing a stock's price by the company's earnings for the previous 12 months. A ratio of 18.8 means investors are paying $18.80 for the right to share in $1 of earnings. When they bid prices up and raise the ratio, they are betting that earnings will grow in the future. The higher the price, the bigger the gamble -- and the riskier the stock.

Although the current P/E of 18.8 is higher than the average of 15.6 tallied since 1935, many experts think the norm today is around 20 to 22, since today's markets are quite different from those of past decades. If so, stock prices look quite reasonable today, and stocks could rise nicely if corporate profits grow.

Bond investors are always concerned about rising interest rates. As newer bonds start paying higher rates -- higher yields -- older bonds that are not as generous become less attractive, and their prices fall. A 1 percent rise in prevailing rates can cause a long-term bond's price to fall by 7, 8, even 10 percent.

But the problem is less serious if rates rise slowly. This allows investors to sell their bonds gradually, or to wait for them to mature. Then the proceeds can be reinvested in bonds with higher yields.

When the Fed raised rates quickly in 1994, bonds took a beating. This time, the Fed apparently wants to avoid that by keeping the pace of rate increases slow.

Bottom line: The future is uncertain, as always. It doesn't seem likely many investors will score big gains in bonds. But stock market investors don't seem to be facing the big risks they did in the late '90s.

So if the good news outweighs the bad, stock market investors could be quite pleased with their results in the next six months.

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