Bulls Take Flight on Dovish Fed

Stocks start 2006 with a bang on the Fed minutes, but some of the buying seemed indiscriminate.
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The minutes of the Dec. 13

Federal Open Market Committee

meeting renewed hopes the tightening cycle is nearly over and sent the bulls charging into 2006.

After trading in the red and hitting a morning low of 10,684, the

Dow Jones Industrial Average

jumped in reaction to the 2 p.m. EST release of the minutes to close up 129.91 points, or 1.21%, to 10,847.41.

The

S&P 500

gained 20.51 points, or 1.64%, to 1268.80, boosted by the energy sector -- as crude oil topped $63 per barrel -- and financials, which rallied on the prospect of the end of rate hikes. The Amex Oil Index soared 4.6%, led by big gains in the likes of

Occidental Petroleum

(OXY) - Get Report

,

Amerada Hess

(AHC) - Get Report

and

Marathon Oil

(MRO) - Get Report

.

The S&P financial sector advanced 1.7% and the Amex Broker/Dealer index rose 1.5% behind strength in

Morgan Stanley

(MWD)

, Lehman Brothers

(LEH)

and

Jefferies Group

(JEF) - Get Report

The

Nasdaq Composite

made the most gains of all three benchmark indices, adding 38.42 points, or 1.74%, to 2243.74.

The minutes all but confirmed the Fed's Dec.13 statement that after 13 rate hikes and a fed funds rate at 4.25%, the central bank believes the end of its current tightening cycle is in sight. In its statement last month, the Fed had stopped referring to monetary policy as "accommodative" to growth.

In the minutes, the Fed went further and gave a hint -- albeit a vague one -- about how much further tightening might still be in the cards.

"Although future action would depend on the incoming data," the central bank chose to stop describing policy as accommodative to indicate that "given the information now in hand, the number of additional firming steps required probably would not be large."

The market's take: The Fed will hike one more time on Jan. 31, lifting fed funds to 4.50%. But the odds that it will do so again on March 28 have now dropped to 56% from 62% previously, according to Miller Tabak.

"The message is that the Fed is not hell-bent on pursuing a restrictive monetary policy that otherwise might put the economy at risk," says John Lonski, chief economist at Moody's and a veteran Fed watcher. "But if the economy responds well

to the Fed pausing its rate hikes, then it may resume

tightening later in the year."

Illogical Bulls

The best-of-all-worlds consensus on Wall Street has been that the economy will slow enough in 2006 to convince the Fed to stop lifting rates, but will remain strong enough to boost profits and stocks.

While top-line growth might not do as well with consumers feeling the pinch of energy costs and declining home equities, profits should continue to rise as long as productivity remains high and labor costs remain under control, says Owen Fitzpatrick, head of the U.S. equity group at Deutsche Bank.

Furthermore, after a disappointing performance in December, the market is now attractively priced with the S&P 500's price-to-earnings ratio currently at 15.4, Fitzpatrick added, summing up his own and Wall Street's consensus view.

Still, on the same day that the Institute for Supply Management's December manufacturing survey came in weaker than expected,

Wal-Mart's

(WMT) - Get Report

December sales disappointed and crude oil stormed higher, legitimate questions can be raised about a slowing economic outlook and its implications for stocks.

Logically, the scenario of a slowing economy/gentler Fed should play in favor of the growing consensus view of Wall Street strategists: namely, that safer large-cap stocks will take over leadership from small-caps, and that less-cyclical stocks, such as health care and consumer staples, will outperform industrials stocks and consumer discretionary.

But the gains were widespread Tuesday, encompassing not only the obvious beneficiaries of the end of rate hikes, such as the financial sector, but the industrials and the retail sector, which rose 1.12%.

James Paulsen, chief investment officer at Wells Capital Management, is mostly amused by the market's logic behind Tuesday's rally. "You look at the industrials and at the basic materials and energy

which are all cyclicals rallying and you wouldn't think this market expects a slowing economy."

There were other reasons for energy to gain -- as mentioned

here -- and the Fed minutes also caused the dollar to tumble, boosting the price of other commodities such as gold, which soared $15.30 to $534.20 an ounce.

Elsewhere, both the S&P 100 index, which compiles the S&P's 100 largest-cap stocks, and the Russell 2000 index of small caps, rose equally -- by 1.6% -- on Tuesday.

Similarly, betting heavily on the riskier technology sector, which gained the most on Tuesday, is not a sign that the market expects a slowing economy (at least not now).

Yet a slowing economy is what the bond market has been signaling since at least late December, when the yield of short-term Treasuries surpassed those of long-term ones several times. This inversion of the yield curve has, in the past, been fairly accurate in forecasting an economic slowdown, or even recession, as was the case with the last inversion in 2000.

Bonds advanced on Tuesday, with the yield curve widening modestly, with the yield of two-year notes at 4.33% and those of 10-year bonds at 4.36%.

Banks should benefit from a bigger differential between short-term and long-term rates, at which they borrow and lend, respectively. But given the weak economic data of late and contained inflation recently, long-term rates have remained low.

And financial stocks shouldn't necessarily benefit -- at least not all financials -- if the economy is indeed slowing. "It's a mixed bag," Paulsen says. "When the economy slows, market activity slows and credit quality worsens."

Paulsen's bullish -- but contrarian -- scenario is that the economy will in fact outperform current expectations and that the Fed will tighten for longer than expected.

It looks like the market, through the Fed, has found a perfect short-term catalyst to rally in the first month of the year. In the short-term, optimism over the Fed's gentler signals doesn't have to translate into logical sector selections, and few complaints were heard about the conflicting signals on this very bullish beginning to 2006.

In keeping with TSC's editorial policy, Godt doesn't own or short individual stocks. He also doesn't invest in hedge funds or other private investment partnerships. He appreciates your feedback;

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