Investors Aren’t Scaring Easily

Something may come along to scare the U.S. stock market down from its current heights. But it may have to be a problem people haven’t seen before.

The usual suspects seem to be losing their ability to frighten investors. That’s often a good sign for a bull market’s staying power.

The blue-chip Dow Jones industrial average is up 5.2% this quarter, its best start to a year since 1999.

Much of the rest of the U.S. market is doing as well or better, which should translate into some happy returns on investors’ first-quarter financial statements.

The advance in share prices lifted the Dow last week to its highest level since 2001 and some broader indexes, such as the small-stock Russell 2,000 and the New York Stock Exchange composite, to record highs.

It’s true that the U.S. market is a laggard compared with the gains racked up this year in many foreign markets. That was the case last year as well.

Still, this probably is a better beginning to 2006 than many investors had expected. If this pace continues, the Dow will be up more than 20% for the year.

You won’t find many people on Wall Street who believe that kind of gain is achievable, however. A Bloomberg News survey last week of seven big brokerages found the average forecast was for a Dow of 11,785 at year-end, which would be a 10% full-year gain. That would mean a 4.5% rise from Friday’s closing level of 11,279.65.

What would it take to make this a 20% kind of year? The temptation is to say, “Everything has to go right.” But then, the Dow has gone a quarter of that distance with plenty going wrong this year.

Oil prices are higher than they were on Jan. 1, and so are long-term bond yields. The trade deficit is up. Congress is rattling the protectionist saber. The housing market is slowing.

More risks loom. The dollar is weakening again, Iraq might yet plunge into civil war, and bird flu could arrive in the U.S. any day.

Yet none of this has been enough to undermine the equity market this quarter.

Maybe investors simply have grown tired of worrying about the ups and downs of oil and bond yields. The shock value is waning.

Or maybe the potential negatives are being trumped by one overriding positive: The U.S. economy is in good shape. The Federal Reserve said as much last week in its latest summary of regional economic conditions, the so-called beige book report.

The Fed said most of its 12 district banks characterized the pace of economic expansion as “moderate or steady” in January and February. Importantly, it said that “employment continued to increase in most locations and in many sectors of the economy.”

That jibes with the government’s report on March 10 that the economy created a net 243,000 jobs in February, the second-best monthly gain in the last 12 months.

Decent job growth has been the missing element of this expansion since 2001. If that tide is turning, it could underpin the next phase of economic growth. More jobs mean more households, more household income, and, eventually, more spending.

Wall Street also is betting on continued good times for the industrial sector of the economy, which is turning out the commodities and heavy machinery that are in demand in many emerging-market countries.

This year’s rally in the Standard & Poor’s 500 index, which is up 4.7% since Dec. 31, has been led by stocks of companies such as grain processor Archer-Daniels-Midland Inc. (up 43% year to date), machinery titan Caterpillar Inc. (up 32%, making it the hottest stock in the Dow index) and railroad Union Pacific Corp. (up 13%).

Union Pacific last week raised its earnings forecast for the current quarter by more than 20%, in part citing growth in commodity hauling.

They may lack the glamour of the technology leaders of the late 1990s, but grimy industrial stocks are getting the job done in people’s portfolios in this bull market. Since the end of 2002, Caterpillar’s stock is up 233% and Union Pacific is up 52%.

Semiconductor giant Intel Corp., by contrast, is up 25%.

John Kosar, head of Asbury Research in suburban Chicago and a longtime analyst of stock and bond market trends, doesn’t take much comfort in the leadership of industrial shares.

Without a strong rally by tech issues the market’s advance this year won’t be sustained, he contends.

Historically, “If tech doesn’t lead, the market doesn’t go up very much,” Kosar said. “When stocks really are doing well, people want to ride the fastest horses,” and that’s often tech shares, he said.

The tech-heavy Nasdaq composite index, which ended at 2,306.48 on Friday, remains below its five-year high of 2,331.36 reached Jan. 11.

Kosar says the broad market is likely to trip soon, although he isn’t sure what the catalyst might be to take it down.

Let’s say he’s right. A market correction may well be overdue, given stocks’ gains since October. (Although bearish analysts were arguing the same thing at the start of the year.)

But one highly anticipated event could make any sell-off short-lived: The Federal Reserve may be nearing the end of its credit-tightening campaign.

Many on Wall Street expect Fed policymakers to announce at either their May or June meetings that they are pausing after lifting their key short-term rate from 1% in mid-2004 to the current 4.5%. (A rate increase to 4.75% at the March 28 meeting seems all but certain.)

How would investors likely react to the prospect of even a temporary halt to the Fed’s rate increases at, say, the 5% level?

Some surely would rush to buy long-term Treasury bonds to lock in yields.

But if the Fed stopped, and if confidence remained high that the economy wasn’t at risk of falling into recession, that almost certainly would be an invitation for investors to take on more risk in search of higher returns. The stock market would be a logical destination for those investors.

In effect, the Fed would be removing a restraint that has held the U.S. market back since the beginning of 2004, when it became obvious that rock-bottom interest rates were going away.

“When people believe with confidence that the Fed is done, equities will probably be the primary beneficiary,” said Anthony Karydakis, chief U.S. economist at JPMorgan Asset Management in New York.

Consider what happened in Britain in 2004 and 2005. The Bank of England raised its benchmark rate from 3.5% in October 2003 to 4.75% by August 2004. It then went on hold.

The FTSE-100 index of British blue-chip stocks rose 9% from the date of the bank’s August 2004 meeting to the end of that year. It then jumped 17% in 2005.

With so many short-term traders in markets worldwide, it isn’t hard to imagine that U.S. stocks would attract a mountain of money once it was clear that the Fed was pausing, if the economic outlook remained upbeat.

How long that money would stay, and how high it might be willing to bid share prices, are anyone’s guess.

But if the Fed in fact is nearly done, the stock market’s performance this quarter could just be an opening act to a surprisingly good year.

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Tom Petruno can be reached at [email protected]. For recent columns on the web, visit: www.latimes.com/petruno.