Capex Siren Call Lures Bulls

Optimism abounds about business spending in 2006. Is it justified?
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A day after its strongest rally in weeks, Wall Street remained under the spell of the enchanting words of

Federal Reserve

members, who signaled Tuesday that the number of additional rate hikes "probably would not be large."

Stocks continued to advance Tuesday, with the

Dow Jones Industrial Average

rising 32.74 points, or 0.3%, to 10,880.15. Blue chips were buoyed by

General Motors

(GM) - Get Report

, which rose 1.7% even after saying its U.S. auto sales fell 4% in 2005.

In another sign of the market's newfound bullishness, a Bank of America research note that was bearish on

IBM

(IBM) - Get Report

but bullish on

Hewlett-Packard

(HPQ) - Get Report

took the former down only 0.1%, while the latter rose nearly 3%.

Tech stocks were indeed in favor Wednesday; Bear Stearns upgraded

Google

(GOOG) - Get Report

, which gained 2.3%.

The

Nasdaq Composite

rose 0.9% to 2263.46. The

S&P 500

gained or 0.4% to 1273.46.

With Wall Street seemingly pricing in a Goldilocks economy -- strong enough to bolster profits but slow enough to take the Fed out of the equation -- some questions arise.

Most crucially, will business capital investment "take up the slack" created by slowing consumer spending if and as the housing market retreats, as Federal Reserve Chairman Alan Greenspan predicted in

June?

More than six months later, a slowing housing market is becoming a reality, and consumers are increasingly pressured by higher rates and high energy costs, while wage gains remain modest.

Wal-Mart's

(WMT) - Get Report

disappointing December sales data revived such concerns and were only partially offset by strong results posted after the bell Wednesday by smaller and specialty retailers such as

Men's Wearhouse

(WM) - Get Report

,

Aeropostale

(ARO)

and

Zumiez

(ZUMZ) - Get Report

.

As for capital spending, Thomson Financial estimates that capital spending at S&P 500 firms was up 24% in the third quarter of 2005 from the year-earlier quarter,

The Wall Street Journal

reported. This compares with an average 9% year-on-year increase per quarter over the previous two years.

Many strategists are expecting that this trend is continuing and will persist throughout 2006. Companies are still sitting on big piles of cash and have overall good credit ratings, leaving them in a good position to expand, should they choose to do so.

To Spend or Not to Spend

Over the past few years, however, firms have increasingly used their cash to boost share-buyback programs, raise dividends and finance acquisitions. Much of U.S. business expansion has taken place outside of the country, such as in Asia, allowing for businesses to stay "lean and mean" and keeping inflation pressures contained.

But with the economic recovery of the past three years in its late stages, some economists believe that firms need to invest more to meet demand.

"Corporate America went into hibernation after 2001 and began emerging from that in 2002," says Ethan Harris, chief economist at Lehman Brothers. Three years later, equipment spending was up 9% in 2005, and it should continue to improve this year. "It's a solid recovery but not a boom."

Still, solid employment growth -- as seen in the November employment report and expected by economists in Friday's December report -- should continue to reduce the pool of available labor. This, of course, means that hiring more employees will eventually mean paying them more, raising inflation pressures.

This leaves Wall Street in a funny position now that the Fed is off of autopilot and will presumably determine future policy moves as the economic data suggest.

Bulls are hoping for evidence of declining inflation pressures and/or signs of economic weakness, as were seen in Tuesday's weaker-than-expected December manufacturing survey by the Institute for Supply Management.

This type of softer data, it is thought, will be bullish for stocks as it will lead the Fed to stop raising rates. Meanwhile, a lot of Wall Street strategists are also using expectations of higher capital spending to bolster their bullish views about the economy and stocks.

At some point, someone will have to revise their expectations -- either the economy will slow or capital spending will rise; a combination of the two seems unlikely. Both the bond and the stock markets are showing signs of "irrational exuberance," says Lehman's Harris, quoting the famous warning made by Greenspan in December 1996.

Markets are expecting at most two more rate hikes from the Fed, he notes, while there should be at least three more. On the one hand, the slowing housing/slowing consumption trend will be countered by rising capital spending/strong employment trend, Harris believes. On the other hand, overall

financial conditions remain easy despite of the Fed's 13 rate hikes.

"The bond market has mostly ignored the Fed, and credit spreads

between corporate and government debt are little changed, stocks have had a decent run, and the banking system is full of aggressive lending schemes," Harris says.

Even if the economy cools a bit, as most economists expect, the Fed may still find itself in need of raising rates to at least 5% from 4.25% currently, the economist expects.

Still, there are some worthwhile plays of the capex growth scenario, according to Citigroup market strategist Tobias Levkovich. He does expect the overall economy to slow during the course of 2006, and that should lead the Fed to step aside, while favoring more defensive large-cap stocks on the whole.

But he does believe that capex spending will increase thanks to

Microsoft's

(MSFT) - Get Report

introduction of Vista, the latest version of Windows, slated for the middle of 2006.

While actual Vista sales likely won't accelerate until 2007, Levkovich believes the equity market may anticipate a big corporate upgrade cycle, which should lift big tech such as Microsoft,

Intel

(INTC) - Get Report

and IBM. This trend, however, would be less beneficial to the likes of Google and

eBay

(EBAY) - Get Report

, he predicts.

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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