September 3, 2006

BY ALEXANDER P. PARIS

An expanding economy, a record string of double-digit quarterly earnings increases, and historically low bond rates add up to a perfect formula for rising stock prices, right? Well, not so far this year. Through Friday's close, the Wilshire 5000, the broadest of all market measures, had eked out only a 4.3 percent gain so far this year. Unfortunately, investors had been spending most of the year unable to decide whether to celebrate good economic news or worry that the Fed will keep ratcheting up interest rates whether the economic news is good or bad. No wonder many were confused and went to the sidelines.

But the good news is that investors finally made up their minds in mid-May, and since that market peak, they have focused all their attention on the economic slowdown. Investors have become much more risk-averse -- selling off economically sensitive stocks and switching to defensive stocks, which have been outperforming.

They also began favoring presumably safer larger stocks over smaller ones. Since the peak, the bond market has rallied, while gold and commodity prices halted their advance -- all signs of weakening economic expectations. Even oil prices have been acting tired lately.

When the Fed finally granted investors their most fervent wish and paused, investors rallied the stock market for all of an hour before they correctly asked why the Fed ceased its tightening.

Was the Fed so concerned about the economy that it was willing to abandon its primary mission of fighting inflation? As a matter of fact, the Fed reduced its forecast for the economy at its Aug. 8 meeting to subpar economic growth for the next year and a half.

Why is all this good news?

Because investors finally have narrowed down to one key question: Is the economy going to have a hard or soft landing? That makes it easier to understand, analyze and try to time the bottom.

The first phase toward building a foundation for a sustained rally is to recognize the problem, and we doubt that anyone with a TV is now unaware of the slowing economy and particularly the rapidly deteriorating housing market.

The second phase is reflecting that recognition in stock prices, including the worst fears about the slowing economy.

We doubt we are yet through the second phase. Estimates for third- and fourth-quarter earnings growth are still over 14 percent, higher than the second quarter, despite expectations of slower second-half growth. The Fed is done tightening, but many investors are not convinced, which means they are not yet frightened enough about the economy. There is also still worse news ahead on housing that should shake investors up a bit more.

At the market's true bottom there should be a sufficient level of anxiety, and either a renewed sell-off or an extended narrow trading range. We would like to hear more talk of an outright recession, and that the Fed overdid its tightening.

The question facing investors should not be "is the Fed done raising rates?" but "when will the Fed ease rates?"

Encouragingly, we are just starting to hear some of this talk.

On the negative side, investors are due to be disappointed on two misconceptions about the Fed. There are high expectations that once the Fed stops raising rates, the stock market will immediately rally. But historically, six months pass before that kind of rally starts.

Secondly, many have been expecting a repeat of big rallies in the 1980s and 1990s following the end of a Fed tightening cycle. But those advances were paced by big bond market rallies starting from high yields of 12 percent and 8 percent respectively. Today, the 10-year 4.7 percent Treasury rate leaves no room for a bond rall; there is more risk of the opposite.

On the positive side, we expect a soft landing for the economy, but we believe it's just too early for investors to be sure. We don't believe the interim downside risk for the stock market is large because the U.S. economy, the banking system and corporate finances are healthy.

Importantly, market price/earnings ratios have been contracting for more than three years, and when adjusted for the low bond rates, the stock market is undervalued. There is lots of equity money on the sidelines to feed the eventual rally.

Further down the road, money now invested in real estate will be finding its way back into the stock market. So the rule for a while should be cautious optimism. Defensive sectors like consumer staples (beverages, food and the like), health care and utilities should continue holding well.

On the cyclical side, the technology sector may be oversold, and local internationally diversified electronics companies like Littelfuse (LFUS) and Molex (MOLX) are attractive. ServiceMaster (SVM), another local company also meets criteria for size, high dividend yield (4.5 percent) and reasonable insensitivity to the economic downturn.