Stocks stay strong despite attacks

Wednesday, July 13, 2005 at 1:00am

It was an impressive week for stocks despite the attacks in London on Thursday and a mediocre employment report on Friday. Stocks still managed to have an up week with the Dow Jones Industrial Average and S&P 500 Index closing at 10,449.14 and 1,211.86, respectively, each up nearly 1 percent, and Nasdaq closing at 2,112.88, up more than 2 percent. For the year, the S&P 500 has clawed its way back to even with the Dow and Nasdaq down only marginally. All the major sectors were up last week, with technology the leader. The futures markets moved up 3 percent on Thursday.

It almost seems that investor confidence has been strengthening in recent weeks. Barron's reports that markets are bouncing back more quickly after terror attacks as the attacks are beginning to be taken in stride. After the World Trade Center bombing in 2001, the S&P 500 fell 12 percent, recovering in two months. The blast in Madrid in 2004 caused a 7 percent fall in the Index, with the recovery occurring in one month. Last week's London attacks caused a 4 percent drop, but by the end of the day Friday, one day later, the losses were covered.

In the bond market, rates moved up across the curve. The 10-year Treasury rose five basis points to 4.10 percent during the week. The futures market is suggesting two additional increases by the Fed. As we have pointed out throughout the year, the market has seesawed, with a deceleration of growth and uneven profit growth expected. Merrill Lynch Economics writes that S&P 500 companies are expected to record second-quarter profits up 7.5 percent versus year-ago levels. This would be the weakest year-over-year gain in two years, due to higher oil prices, a firmer dollar and continued Fed tightening. The energy sector is expected to show gains of 30 percent year over year. Excluding energy, S&P 500 gains are anticipated to be less than 5 percent. We think results may be a little better than that. That the market has recovered so well after Thursday's attacks in London suggests that the global economy is in reasonably good shape and there is high confidence that monetary and other authorities would act to promote growth, if necessary. However, last week reminded us that geopolitical risks are higher than they have been in quite some time.

It is clear in our minds that policymakers will maintain a pro-growth bias. Among central banks, the Fed is one of the lone holdouts, but virtually everyone agrees that tightening is in its later stages. In fact, countries where policymakers have backed off from tightening and where interest rate expectations are easing have enjoyed the strongest financial market performance so far this year. Many of the stock markets of the world are at or close to new cyclical highs. The U.S. market is one notable exception but could catch up later this year when the Fed finally does retreat. Our view is that at worst a soft economic landing will occur. The economy has been resilient despite the drag from a strong dollar, a hawkish Fed and higher energy prices. The other side of this economy is the Fed staying hawkish, which may provide further squeeze in the profits we expect to see in the second half of the year. These are the shorter-term risk factors and the bigger picture outlook is only a mild mid-expansion economic and profit slowdown. However, this would imply there should be several more years of good growth following this slowdown before a recession becomes a significant threat. All this should be reasonably good news for equities.

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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