The Wall Street rally can't last
Aug 30, 2006
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After its turbulent patch earlier this summer, Wall Street has been in a more benign mood this month. The S&P 500 rose every day last week, as investors took heart from a combination of positive earnings, economic growth, moderating inflation, a Middle East truce and lower oil prices, says
Dave Shellock in the FT.
US core consumer prices rose only 0.2% in July, lending weight to the view that the Federal Reserve will “declare at least a partial victory over inflation” and use that as an excuse “to reverse the reloading of the interest rate gun”, says Eoin Treacy on Fullermoney.com. “I do not believe inflation can be brought under control at current rates but it can temporarily abate. This will set us up for a good stockmarket rally, as rates are lowered to protect the economy.”
But while this may point to short-term strength, the long-term outlook is not encouraging. Falling interest rates aren’t necessarily a prelude for a resurgent bull market, as Alan Abelson points out in Barron’s. After the bursting of the dotcom bubble, the Federal Reserve began cutting rates in August 2000 and the market rallied in response – but not for long. Within a year, the S&P was down 26%. Six years on, another great bubble – the US housing market – is in the process of bursting and the economic fallout could be even more severe, suggests Abelson.
“A remarkably cosy consensus” has developed on inflation, says Michael Santoli, also in Barron’s; markets are seizing upon any signs that inflation could be moderating and rates could be cut, but paying scant attention to a looming downturn. Even some commentators who are very dovish on US interest rates think that the markets are far too optimistic about the impact of any cuts. “We expect Bernanke to cut rates to 3.5% next year – far more than markets are currently pricing in,” says Simon Hayley of Capital Economics. “But even this cannot be expected to prevent equities from falling as slowing growth hits corporate earnings.”
The problem is that equities are in a bubble, says Gerard Minack of
Morgan Stanley. Unlike the 1990s bubble, which took the form of insane p/e ratings, this bubble is in unsustainable earnings growth. “What will pop [this] are signs of growth and earnings downgrades. Those downgrades seem to be looming.”
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