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The U.S. Stock Market – The Looming Uncertainty

By Scott B. MacDonald

Markets hate uncertainty. Unfortunately that is the one thing that is in great abundance at the present time. Brutal and deadly attacks against foreign oil workers in Saudi Arabia, ongoing conflict in Iraq, China’s threatening behavior vis-à-vis Taiwan, North Korea’s nuclear threat, and angst over interest rates in the United States have opened a Pandora’s box of investor anguish. Even the U.S. presidential election offers no comfort as opinion polls indicate a close contest. Yet there are other, more positive signals – strong corporate earnings, ratings upgrades, and robust economic growth over the last two quarters. Malls are reporting a lot of foot traffic as the intrepid consumer is still out buying goods from Wal-Mart. Consequently, the U.S. stock market resembles a rollercoaster as bulls and bears seek to push and pull investors along. Who is right? Are we heading into another bull market period or is there another lap in the multi-year bear market looming? We lean toward the later.

The bulls argue the U.S. economy has returned to a path of sustainable growth, which in turn will help rectify the fiscal deficit and current account imbalance. The worst is over as strong economic growth will translate into corporate America going out and hiring. At last, the lagging indicator of unemployment will fall – just in time for George W. Bush to win re-election. The war against international terrorism will continue, but is likely to be controllable. There is only a small likelihood that a major attack will occur in the mainland United States – the struggle against the Axis of Evil and its allies is to be found elsewhere.

While some of the above bull scenario is accurate (stronger and most likely sustainable growth as well as an improved corporate performance), some of it is overoptimistic. The bears do have some valid points. The U.S. economy is carrying too much debt. According to Standard & Poor’ U.S. households continue to set new debt records, with total debt (as of April 2004) at 113% of after-tax income. The consumer at some point must step back and replenish savings as the housing market is going to cool and employment generation remains a gradual process. We have already seen some correction in the housing market as the most recent data showed an 11.8% decline in new home sales -- the largest drop in 10 years according to the U.S. Department of Commerce.

In addition, the fiscal deficit and current account imbalance are not going away anytime soon. The latter could be greatly complicated by the trade policies of both the Democrats and Republicans, as both appear equally keen to be seen as the greater protectionist. Consequently, we have moderately strong economic growth, but weak confidence; improving performance from the corporate sector, but a slow approach to hiring; and a nation dependent on foreign trade and capital flows, but lead by political parties preaching protectionism.

How does all of this play to the stock market? The short answer is not very well. It sets an uncertain path in the weeks ahead. June 30 looms as a potential swing date – the FOMC meets to decide on interest rates and the U.S.-led coalition is scheduled to hand over sovereignty to an Iraqi government. Both events are important. The market anticipates an increase in interest rates to begin a new cycle. The Fed has claimed it will begin with a measured approach. We believe it will increase rates by 25 bps in June, again in August (25 bps), and possibly once more before the year-end – if the economic data supports such an action. There is a deep concern that if the Fed moves too quickly as it did in 1994, it could slow growth. We do think the path to raising rates and containing inflation must be carefully balanced with the fragile condition of the consumer and the housing market. There is a possibility if growth is slowed too much, these two parts of the economy could plunge – and that would certainly send the market into a tailspin.

As for June 30 and Iraq, the Bush administration has invested a considerable amount of its political capital into knocking out Saddam Hussein and replacing his dictatorship with a democracy. The invasion of Iraq was also expected to provide the American-led world order with longer-term benefits. By holding Iraq, the Americans could bring Saudi Arabia, Iran and Syria under pressure to make changes in their countries – along the lines of western democracies, while also putting acute pressure on the state sponsors of anti-Israeli terrorist groups.

Instead, the Bush administration underestimated the Iraqi resistance of the former regime (and new Islamic Jihadists), has been embarrassed over the alleged justification for the war (weapons of mass destruction which have not been found), and is now seeking United Nations help in finding a way out of the Iraqi mess. June 30, if all proceeds well, will begin to take the monkey off the back of the Bush White House. If it is postponed or the new interim government is unable to restore order (which is a distinct possibility), the turnover could be problematic, adding to market uncertainty (not to mention pressure on international oil prices).

Post-June 30, markets will still have to confront uncertainty around the U.S. presidential elections, which we expect to be very close. We still regard the contest as Bush’s to lose, considering that Senator Kerry has not made a sufficient distinction between himself and the President in the minds of many voters, the divided nature of the Democratic Party (between the liberal and moderate wings which is hurting his ability to make a clear-cut message), and the gradual improvement in the economy. The Green Party candidacy of Ralph Nader could also hurt Kerry in a close election, much as it did Al Gore in 2000.

Despite that, Kerry has a track record of being a strong campaign finisher – as witnessed during the primary season in his performance against Howard Dean -- and there remains a lot of things that can still go wrong for the Bush presidency in terms of the economy and geopolitically.

We are in a multi-year bear market, which commenced in 2000. Considering the relatively fragile nature of market confidence, we think there is a strong chance of another pronounced downward leg in the Dow before the end of the summer. It could be precipitated by another major terrorist attack in the United States, a string of bad economic data or a confluence of negative factors on June 30 (a botched handover in Iraq and a sharp hike in interest rates). It is going to be a long hot summer for the stock market and gold is probably going to look better as the months move along. We should add that although the short-term looks potentially rocky, we do not see the U.S. economy falling back into a recession and the stock market toward the end of the year could have some bounce as some of the current uncertainties diminish.