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Ask the Fed About a Year-End Rally

A move higher depends on falling oil, and on how worried the Fed really is about inflation.
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For the rest of 2005, the stock market will be a battleground between hopes for lower oil prices and fears of higher interest rates. If oil prices fall, stocks -- in at least a few select sectors -- are likely to jump.

But that won't happen until the markets are through worrying about what Alan Greenspan & Co. will do and say about interest rates on Nov. 1. If the


signals that it is more worried about inflation -- and inclined to raise interest rates more aggressively in response -- I think we could see a decline that takes the major indices down 5% to 10%.

That kind of a selloff would be the signal to buy in anticipation of a typical end-of-the-year rally.

The price of crude oil looks like it has hit a temporary top. When the price for a barrel of crude (light, sweet crude for December delivery, to be exact) dropped below $63 last week, it broke the short-term uptrend for oil prices, according to Philip Erlanger, editor of the

Erlanger Squeeze Play

newsletter. Now that oil has fallen through technical support at $63 -- it traded below $61 on Monday -- it could well drop back to $55 a barrel.

The price of oil futures is also signaling a moderation in price increases. Back in mid-June, oil for September delivery was at $58.20 a barrel, according to the U.S. Energy Information Agency. At that time, the market clearly expected oil prices to rise and rise fast. A contract for December delivery was priced at $60.02 a barrel, almost $2 more.

That spread has narrowed in recent weeks, to 74 cents on Oct. 4. The energy market thinks oil prices will continue to rise, but much less rapidly. If you look even further out, the commodity market is forecasting flat crude oil prices in the second half of 2006, according to Bernstein Research.

While $55 may look cheap compared with recent highs near $70, it would represent a 27% increase in the price of crude since the beginning of 2005. That's good news compared with where we've been. At the end of September, crude oil was up 52% since the beginning of 2005. Knocking that change back to 27% would be a huge improvement. It would be even better if, by December, that change narrows down to 16%, as the futures market suggests.

That's because it's the speed at which energy prices are rising that has the most impact on consumer and corporate behavior. Given enough time, consumers will change habits, invest in energy-saving technologies, work more hours -- or go deeper in debt. And they'll keep spending. Companies will cut costs, improve efficiency and pass along energy-cost increases to customers -- or go deeper into debt. Thus, they'll compensate for higher costs, maintain profit margins and keep earnings growing at double-digit rates. The economy, still largely powered by consumer spending, will continue to chug along.

Split Personality

Current Wall Street expectations, however, assume that quickly rising energy prices will ding third-quarter earnings. To understand how oil has created modest expectations on Wall Street, however, you have to divide stocks into two groups: energy and non-energy.

So far, 2005 has been a great year for energy stocks. Energy stocks in the

Standard & Poor's 500 Index

climbed 30% in the first three quarters of the year. It's been a crummy year for the rest of the market, and it's much crummier than the overall market indices indicate. For the first three quarters, the overall S&P 500 index lost 1.7%. Take out energy stocks, which account for 10% of the index, and the loss is more than twice as large: 4%, S&P says.

It's the same story with earnings. On the surface, Wall Street is expecting another stellar quarter of earnings growth. Thomson Financial says analysts are projecting that earnings for the S&P 500 climbed 16.4% in the recently completed September quarter. That would be a healthy rebound from the 11.7% growth recorded in the second quarter.

If earnings are going to be so great for the third quarter, why hasn't the stock market been going up? According to Thomson, the energy companies in the S&P 500 are projected to grow earnings by 71% in the September quarter. Non-energy company earnings are projected to grow by just 10%. That would be even lower than the 11.7% earnings growth of the second quarter and provide solid evidence for those on Wall Street who argue that the economy is slowing.

The picture for the fourth quarter isn't any better. In fact, it's worse if you remember that the fourth quarter is historically the strongest of all the quarters of the year. That's because consumers and businesses concentrate so much of their buying into the end of the year. Wall Street currently projects S&P 500 earnings growth of 16.5% for the fourth quarter. That becomes projected growth of just 12.3% if you look just at non-energy earnings. Quite a comedown from the 19.7% growth in the fourth quarter of 2004.

The lower investors' expectations are for fourth-quarter earnings, however, the easier it will be for companies to exceed them. And nothing drives stock prices higher than a string of positive earnings surprises. Wall Street will be watching third-quarter earnings reports to see if companies sound positive about the fourth quarter, no matter what problems they've encountered in the third quarter. Raised earnings guidance from a few companies could become contagious and set Wall Street's mood swinging back toward hope from fear.

In some markets, lower earnings expectations, a potential earnings catalyst in lower energy prices and the shift from the worst two months of the year for stocks (September and October) to the seasonally strong end to the year would be enough to make me put new money to work in mid-October, to bet on an end-of-the-year rally.

Fed to Get Tough?

But not this year -- because the Fed's Open Market Committee, the group that sets short-term interest rates, meets on Nov. 1. Lately, as we know, the Fed has been acting like it wants to get more aggressive -- read that as more and perhaps faster rate hikes -- in its fight against inflation.

Alan Greenspan's Fed has been adamant about telling the market where federal funds rates are headed before it acts. And it sure looks like the Fed is signaling it will raise rates another quarter-point to 4% on Nov. 1 and raise again in December. Last week, Dallas Fed President Richard Fisher said the Fed can't "let the inflation virus infect the blood supply and poison the system."

Fisher was the third regional Fed president in the week to warn publicly about inflation, and he actually issued not one but two warnings.

In August, consumer prices climbed 3.6% from a year earlier. The core measure of inflation, which excludes energy and food prices, climbed just 2.2%. At one time, that would have comforted the markets and the Fed. But, with high oil prices apparently here to stay, the Fed seems increasingly uncomfortable leaving energy inflation out of its calculations.

With the financial markets widely expecting the Fed to raise short-term rates in November, fear is focused on what the central bank has to say in its public post-meeting announcement. For months, the Fed has maintained that "longer-term inflation expectations remain contained" and that "policy accommodation can be removed at a pace that is likely to be measured." Any change in that wording that suggests the Fed is more worried about inflation or is considering quickening the pace of interest rate increases from "measured" would lead some investors to sell.

Skip Energy in the Year-End Rally

I'd use the nervousness leading up to the Nov. 1 meeting and any decline on a wording change from the Fed to place my short-term trading bets for an end-of-the-year rally. What would I be looking to buy? Not energy stocks. Although this sector remains among my long-term favorites, any end-of-the-year rally will be built upon a decline in oil prices, which will send energy stocks lower. Not financials, because interest rates are going up -- even if maybe not as fast as we fear in our nightmares. Not retailers, because the holiday season is indeed looking weak.

I think the best bet for an end-of-the-year trade remains the tried and true one: technology stocks. They're not energy-intensive and not especially sensitive to interest rates, and their sales are loaded into the fourth quarter.