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Bullish on America

Stocks rose last week despite Hurricane Katrina. But is the trade ignoring some tough realities?
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Through all the gruesome imagery, the government missteps and the fear of a 21st Century energy crisis, stocks somehow managed to rise in the wake of Hurricane Katrina. Why the optimism?

Not since 9/11 has national psychology taken such a hit. A major city is in danger, while infrastructure networks supporting southeastern energy, transportation and health care are hobbled. Consumer confidence, already precarious before Katrina, looks likely to tumble.

Economically, oil's tax on both industrial and consumer enterprise has worsened appreciably. Crude futures spent much of last week trading near $70 a barrel, with gasoline shortages calling to mind the worst days of the 1970s oil crisis.

Add to this a long winter of higher home heating bills, and many analysts have argued that a recipe is in place for recession.

But in Wall Street's cold, calculating view, natural disasters are often opportunities, as money flows from the public and private sectors into reconstruction. Meanwhile, many traders assume the oil supply crunch will be brief, but maybe not brief enough to keep the

Federal Reserve

fixated on tightening.

"Hurricanes usually actually have a net positive effect when it comes to corporate profits," said David Dropsey, a research analyst with Thomson First Call.

Those sentiments gave rise to cautious buying last week, sending the

S&P 500

up 1.4%, while the yield on the 10-year Treasury bill dipped to 4% from 4.2% seven days earlier. As a result, Alan Greenspan's "conundrum" of converging short- and long-term bond yields remains very much intact, despite 10 straight quarter-point rate hikes.

Now, Wall Street is in the process of pricing in a pause in the Fed's "measured pace."

"I could see the Fed leaving rates where they are at the next meeting in order to give the economy a chance to absorb this shock and respond to it," said Barry Ritholtz, chief market strategist with Maxim Group and a columnist for's

Web sites. "We fully expect them to continue on their prior path next month. But if they take a break, we'll be at 4% going into 2006 rather than 4.25%."

Following a meeting between President Bush and Greenspan last week, the market was pricing in a 72% chance of another quarter-point rate hike at the next Federal Open Market Committee meeting on Sept. 20, down from the previous 90%. If rates are raised in September, then the market has priced in only a 20% chance of a hike in November, down from 100% at the beginning of last week.

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With that in mind, investors left their money in equities, betting that the hurricane would only prove a temporary soft spot for the economy.

"Even though this is a disaster of epic proportions and great tragedy, the U.S. economy has proved to be amazingly resilient in the face of such disasters in the past and I see no reason why it shouldn't be this time," said John Bollinger, president of Bollinger Capital Management. "I don't think this is a material event in terms of the marketplace."

While there has been a lot of talk of lowered expectations for earnings and economic growth in the back half of 2005, few analysts or economists have taken their actual forecasts down -- at least not yet.

"A lot of analysts are in a wait-and-see mode," Dropsey said. "Right now, we're at 13.9% estimated growth for all of 2005 and the quarterlies have not changed for the third and fourth quarter."

Still, when analysts do begin to act, it will be interesting to see how the market behaves. While some companies will benefit from the rebuilding effort, the complete shutdown of a major American city and port is almost certain to leave a hole in the overall earnings picture. At



alone, the

Associated Press

reported, 120 stores were closed last week in Louisiana and Mississippi.

Meanwhile, if the supply shock in energy markets continues to drive prices higher, a pause in the tightening of the money supply could be the last thing on Greenspan's checklist as he faces retirement. After all, oil prices drove the government's consumer price index to a higher-than-expected 0.5% gain in July. If inflationary pressures are picking up with long-term rates still languishing, Greenspan might be inclined to do everything he can to rein in liquidity on his way out.

Meanwhile, still-soaring housing prices, driven largely by the low-rate environment of recent years, is a form of inflation that doesn't show up in the consumer price index. While Greenspan is not predicting the bursting of a housing bubble, he did acknowledge that the market is poised to "simmer down."

"Housing turnover will decline from currently historic levels, while home price increases will slow and prices could even decrease," he said at the recent Fed retreat in Jackson Hole, Wyo. "An end to the housing boom could induce a significant rise in the personal saving rate, a decline in imports and a corresponding improvement in the current account deficit."

A driver of such a scenario could be higher long rates. Of course, the long-awaited rise in interest rates might not be such a smooth ride when it finally comes. The Commerce Department reported last week that consumers spent $59 billion more than they earned in July, at an annual rate, sending the personal-saving rate into negative territory for the first time since the weeks after 9/11.

Consumers have been living on borrowed money for years now, and last quarter's round of retail earnings showed signs that higher fuel costs are finally hitting pocketbooks. Higher costs wrought by Katrina, coupled with higher borrowing costs sometime in the future, could reduce consumer spending to a trickle.

"You can't permanently spend more money than you make as a society or an individual, and right now, that's what we're doing on both levels," said Chris Hackett of Greenwich Investment Advisors. "You can do it for a little while, but you can't do it forever. And it usually takes some sort of catalyst to bring a situation like this to a halt."

Could Hurricane Katrina be such a catalyst? Maxim Group's Ritholtz thinks not. He said the relative strength in the stock market shows there is still an appetite for risk, and that could bring more gains to stocks before the end of the year.

"It's when we get to the end of this year and 2006 that things start to look nasty," he said. "A slowdown in consumer spending looks inevitable at some point. Gasoline is up a buck over the past week, and that's a very significant impact. It's definitely dangerous."