The month of March turned out to be pretty good for stocks, capping an even better performance for the first quarter. The Dow Jones Industrial Average advanced 1% in March and 3.7% in the first three months of 2006. The S&P 500 rose 1.1% for the month and 3.7% for the first quarter. The Nasdaq Composite performed the best, advancing 2.5% in March and 6% over the past three months. This was the best first quarter for the S&P 500 since 2000, according to Bloomberg. The energy and materials sectors were the best performers of the broad index, closely followed by the telecom sector. Amid end-of-quarter portfolio adjustments on Friday, the Dow fell 41 points, or 0.37%, to 11,109, the S&P fell 0.4% to 1294 and the Nasdaq dropped 0.04% to 2339. The market's performance was mixed for the week, as investors digested another hike by the Federal Reserve on Tuesday and signals of more to come. The Dow dropped 1.5% and the S&P fell 0.6%, but the Nasdaq climbed 1.2% on the week. The Nasdaq was boosted this week, in part, by strength in Google ( GOOG) early in the week in anticipation of the Internet search giant's inclusion into the S&P 500 on Friday. Still, Google dropped 5.8% in the quarter after hinting in early March that its profits wouldn't rise exponentially forever. In other corporate news, bankrupt auto-parts supplier Delphi is seeking to void its labor contract with the United Auto Workers, after the union rejected Delphi's demands to cut wages and benefits. Delphi also said it would seek to shed "unprofitable" supply contracts it currently has with General Motors ( GM). GM still rose 1% on the day. The stock market might relax a little with the next Fed meeting six weeks away and the first-quarter earnings season just a few weeks away. "We're not going to feel the impact of these rate hikes for quite some time," says Marc Pado, market strategist at Cantor Fitzgerald.
For over a month, stocks have been gyrating around speculation about when the Fed would stop raising rates, with some even hoping that Tuesday's hike might be the last. Strong economic data made bonds and stocks fret, amid concerns that the Fed would go further. Now that the Fed said it likely will do so, the market can view strong economic and think "that's why the Fed raised rates," says Pado. The bond market, however, has been having a much rougher time this quarter. Bond yields (which move inversely to price) have moved sharply higher. As the Fed lifted interest rates twice more (including on Tuesday) this past quarter, the yield of the benchmark 10-year Treasury bond rose to 4.85%, a level not seen since before the Fed began raising rates in June 2004. A big upswing took place this week -- the 10-year's yield rose over 20 basis points from 4.64% last Friday -- as the Fed delivered its 15th rate hike in a row and repeated that "some further policy firming may be needed." Bond yields have continued to pressure stocks whenever they've risen, but stocks have seized on any reprieve to push higher. On Friday, bond pits first breathed easier after the Fed's favorite inflation gauge -- the core personal consumption expenditure index -- rose just 0.1% in February after a 0.2% increase the previous month. But hopes that the Fed will soon end its tightening campaign were reassessed after Kansas City Fed President Thomas Hoenig made some fairly hawkish comments. The economy remains "rather robust" and is moving toward full capacity, Hoenig said. Markets were also surprised at the timing of the speech itself, which broke with tradition that Fed officials didn't comment about the economy or policy in the week that followed a rate decision.
"This may be a sign of a relaxation of
Fed rule and an effort at increased transparency," writes Tony Crescenzi, interest-rate strategist at Miller Tabak and a RealMoney contributor.
Be Careful What You Wish ForNew Fed Chairman Ben Bernanke has indeed vowed to be more transparent about the central bank's thinking behind monetary decision. On Tuesday, the Fed's statement clearly signaled the Fed's intent to hike rates at least one more time. The market currently sees 100% chance that the Fed will hike its key rate to 5% in May, while odds of a move to 5.25% in June are up to about 30% from zero last week. Still, the market may find comfort in the Fed's statement -- echoed by Hoenig -- that the central bank is hawkish short term (admittedly, an undefined period) and dovish longer term with growth expected to slow in the second half. Stock players have feared that the Fed would hike rates too much, taking down the economy and profits in doing so. The suggestion that economic growth will likely slow later this year -- and that the Fed will stop raising rates -- therefore sounds bullish on the face of it. Yet as economic growth slows, profits are likely to slow as well, even if there's not a direct correlation between the domestic economy and U.S. profits, as many firms derive their revenue from overseas. Rather, profits go through cycles, argues Richard Berner, U.S. economist at Morgan Stanley. Profit margins have exploded since their trough in 2001, he says. This was largely due to strong operating leverage -- a higher proportion of fixed costs than variable costs -- falling interest expense and subdued labor costs. (Indeed, this week the government said pretax corporate profits rose 14.4% in the fourth quarter vs. the third, the strongest pace since 1992.)
But these factors are likely to fade at this stage of the cycle, Berner writes. High operating leverage resulted from firms spreading their fixed costs -- for depreciating assets -- over the past four years. That phase has run its course. Meanwhile, rising interest rates and a tightening labor market, the unemployment rate remains below 5%, are removing the other two key benefits of the latest profit cycle, according to Berner. These factors will be somewhat offset by rising profits from overseas and increasing pricing power, as some firms are able to pass on higher production costs (mostly from energy). But according to Berner's calculations, profits for S&P 500 companies are going to rise only 7.5% in 2006 compared with 14.1% in 2005. That's also almost half less than the 13.3% Wall Street analysts expect on average. "Earnings shortfalls may come as a surprise to equity markets over the next few quarters," Berner warns. This will take place even as Berner expects the economy to grow more this year than last.