Equity market rally comes to a halt

Wednesday, June 29, 2005 at 1:00am

Last week brought a turnaround in the equity market rally that had been occurring for the last several weeks, with every sector in the market (except utilities) posting negative returns. One of the main culprits in the downturn was oil, which climbed to a record high price of $60 per barrel. Additionally, the specter of economic deceleration continued to dampen markets, as last week featured a lower-than-expected Leading Economic Indicator series, disappointing durable goods data and profit warnings from several companies. For the week, the Dow Jones Industrial Average dropped 3.1 percent to close at 10,297, the S&P 500 Index lost 2.1 percent to finish the week at 1,191, and the Nasdaq Composite fell by 1.8 percent to 2,053. Fixed income markets fared much better, with bond yields (which move in the opposite direction of bond prices) declining. The yield on the 10-year Treasury once again moved below the 4 percent level and closed the week at 3.92 percent.

All eyes will be on the Federal Reserve when the Federal Open Market Committee meets later this week. It is widely expected that the Fed will announce another 25-basis-point increase in the federal funds rate, which would bring the rate to 3.25 percent. Observers will be scrutinizing the accompanying announcement for signs that an end to tightening may be near given the mounting evidence of an economic slowdown. Several factors have been detracting from economic growth so far in 2005, particularly the rise in oil prices, increasing short-term interest rates and the recent strength of the U.S. dollar. These factors have been offset somewhat by low long-term interest rates and the strength in the housing market. Regarding how much further the Fed will go, the fed funds futures curve is forecasting a couple of additional rate hikes before we see the end of the current tightening cycle and is predicting a year-end rate of 3.75 percent. We continue to believe that the fed funds rate will end the year slightly lower than that, at 3.5 percent.

Although we have been focusing on some of the negatives for equities, we do believe that there are a number of positive factors that could help drive stock prices higher. First, on a global scale, despite the cyclical rise in inflation we have seen over the past few months, deflationary pressures still exist, which help support equity valuations. Second, continuing low long-term interest rates should be a positive for economic and corporate profit growth. Third, many central banks around the world are expanding monetary policy by lowering interest rates, which should help combat global economic weakness and provide a lift for stocks. Fourth, given that profits and earnings have grown significantly over the past several quarters while stock prices have remained relatively flat, equity valuation levels have improved. And finally, cash investments are not currently providing attractive returns, which should help move some investors into the stock market. As we stated earlier, however, equities are experiencing some headwinds, including slower economic growth and rising oil prices. Our belief is that until the Fed stops raising rates (or gives a clear sign that the end is near), equity markets will continue to struggle.

Bob Doll is president and chief investment officer of Merrill Lynch Investment Managers. For more information on MLIM, e-mail mlim_feedback@ml.com.

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