For Markets, a Pair of Tired Leaders

Housing and energy again drive stock market upside.
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Stocks continued last week's uptick Monday, fueled by a big energy merger and news that housing activity was stronger than expected in March.

In its rebound from what many called an oversold state, the market has been trying to find real drivers for sustainable upside. Unfortunately, the bullish news Monday came from two sectors -- oil and housing -- in which momentum has grown long in the tooth.

That doesn't necessarily spell big trouble for the market in the near term, as valuations have come down in March and April while first-quarter earnings and profit outlooks are so far looking strong. Profits appear on track to rise 12% from last year's first quarter, above previous expectations that they would rise 8%.

Maybe the profit outlook isn't as bad as a nervous market had recently priced in. As mentioned here last week, cautious market strategists such as Banc of America's Tom McManus believe that slightly more exposure to equities is warranted, given the downtick in valuations and increased appetite for risk.

Yet, a swift shift toward more optimism might be the last thing the market needs, especially when it's being fueled by energy and housing.

The

Dow Jones Industrial Average

rose 84.76 points, or 0.83%, to 10,242.47 Monday, while the

S&P 500

gained 9.98 points, or 0.87%, to 1162.10. The

Nasdaq Composite

finished higher by 18.59 points, or 0.96%, to 1950.78. All three major indices finished above their best closing highs of last week.

Breadth was positive, with advancers beating decliners 3 to 1 on the

New York Stock Exchange

, where 1.77 billion shares changed hands. Gainers beat losers 3 to 2 on the Nasdaq, where 1.44 billion shares were traded.

Market sentiment was aided by other merger news as

MCI

(MCIP)

eased up on its hard-to-get stance by recognizing that

Qwest's

(Q)

takeover offer was above

Verizon's

(VZ) - Get Report

. And buyout firm

Hellman & Friedman

is taking

DoubleClick

(DCLK)

private at $8.50 a share.

Another kick came from news that

Valero Energy

(VLO) - Get Report

plans to buy

Premcor

(PCO)

for $6.9 billion to create North America's largest oil refiner. Clearly, the market gets the best of both worlds when merger activity, which has made a comeback since last year, meets the energy sector, which has been the market leader.

Energy stocks managed to post yet more gains, with the NYSE energy sector index rising 1.16%.

This week will see a number of earnings reports from the energy sector. The profit picture will be closely watched at the likes of

Exxon Mobil

(XOM) - Get Report

and

ConocoPhillips

(COP) - Get Report

-- and don't be surprised if good news gets sold.

Banc of America expects that earnings from the integrated oil group will rise on average 37% from last year's first quarter, reflecting sky-high oil prices.

And as oil prices seem more and more to resist falling below $50 per barrel, it seems that profits could remain swollen well into the year, suggesting that the energy sector will remain an exciting place in the market. It's almost impossible to find another sector in which Wall Street pundits are more uniformly bullish.

But how long will the energy sector be able to drive equities, while taking its pound of flesh from economic growth?

'This Time It's Different'

The biggest overhang in the sector remains the high price of oil. Does anyone see it falling? Well, in several reports in April, Merrill Lynch notes that energy stocks, and oil prices, have recently levitated in the same fashion as late-1990s Internet stocks, before the bursting of that bubble.

Merrill analyst David Bowers notes that investors' belief in China's infinite expansion mirrors the '90s belief that the New Economy would defy previous economic and business assumptions.

And Merrill chief U.S. strategist Richard Bernstein notes that after Goldman Sachs suggested certain "super-spike" scenarios could take oil above $105 per barrel, there is now talk in some corners of an "ultra-spike" that could lead oil to $380 per barrel within 10 years.

"We commented in jest several weeks ago that forecasts for oil prices were sounding remarkably like price targets on Internet stocks during the bubble," Bernstein says. "We shouldn't have said it in jest."

Bowers also notes that in 1999, few believed that the Fed's tightening would slow the economy. Few now believe that the Fed or oil prices have done enough to crimp growth. But it's now 10 months since the Fed began to hike in baby steps, and the bite should start being felt soon. Rates likely will continue rising, as indicated by Fed governor Donald Kohn in a late speech Friday. According to

Bloomberg

, Kohn said policymakers "have not yet finished" lifting rates to curb inflation.

Ironically, the most dangerous time for energy assets will be when U.S. consumer spending growth slows, which would adversely impact the U.S. supply chain in Asia, Bowers says. A combination of higher rates and oil prices could very well do that over the coming months.

"When that happens, the stocks that investors today are talking about as the new 'growth' stocks may find that their cash flows are a lot more cyclical than they realized," Bowers says, adding that his concerns may be premature.

Existing Home Sales Beat Forecasts

Contrary to expectations that the Fed's rate hikes are taking a bit out of housing activity, one of the main pillars of consumer spending over the past several years, existing-home sales rose more than expected in March.

Sales advanced 1% to an annual rate of 6.89 million in March, above expectations for a rise to 6.80 million. And existing-home prices rose 11.4% to $195,000 during the month. Homebuilding stocks such as

Hovnanian

(HOV) - Get Report

and

Lennar

(LEN) - Get Report

rallied on the news. The Philadephia housing sector index rose 2.19%.

Yet, housing has shown signs of cooling as evidenced by other March data, such as housing permits and housing starts, notes Wachovia's economics team. And existing-home sales tend to lag new-home sales, which will be reported Tuesday.

In the meantime, demand for houses from people who can actually afford them has peaked, says

Economy.com

. The strong March existing-home sales were boosted by increasing demand for subprime loans.

Both of these sectors have had seemingly endless rounds of "bubble" calls over the past six months. But it remains possible that oil and the U.S. housing sector -- and consumer -- are on a path of mutually assured destruction.

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 invites you to send

your feedback.