Oil, rates and the year-end rally

[notiCIas]

Oil, rates and the year-end rally

Inflation agitation has hit stocks in October. Will it knock the 'Santa Claus' rally off the table?

October 6, 2005: 3:09 PM EDT
By Alexandra Twin, CNN/Money staff writer


NEW YORK (CNN/Money) - Worries about everything from inflation to higher interest rates to slower economic growth have forced the stock market to three-month lows this week.

And the selling for the month may not yet be over.

But a sluggish stock market in October is hardly unusual and Wall Street pros say that despite the considerable head winds, the market is still likely to mount its traditional end-of-the-year rally.

"I wouldn't bet the farm, but I think the outlook for stocks the rest of the year is pretty positive," said Paul Rabbit, president of money manager Capital Management.

There are, without question, a host of issues for the market right now, Rabbit said, noting the short-term impact of the recent hurricanes on an economy already struggling with higher energy prices, the reality of higher inflation and the likelihood that the Federal Reserve will keep raising short-term interest rates through January, the end of Chairman Alan Greenspan's term.

"That having been said, stocks are the cheapest asset class out there relative to real estate and bonds," Rabbit added. "You may see more people moving their money to cash, but for people who want to invest, that (stocks) is where it's going to go."

Stocks were overvalued in the late 1990s and bonds were undervalued, but right now it's the opposite, said William Hummer, principal at money manager Wayne Hummer Inc.

He noted that last month, the S&P 500 fell to a price-to-earnings ratio of about 14.5, the lowest in three years. And the S&P 500's P/E based on next year's expected earnings is 15.2, meaning the stocks in the index are expected to remain reasonably priced relative to earnings.

Third-quarter earnings are currently forecast to rise 17.8 percent from a year ago, according to Thomson/First Call, a fairly strong number considering that the quarter includes the impact of the hurricanes. But downward revisions to these numbers are likely in the next few weeks.

Don't fear October
So far in October, the Dow is down 2.4 percent, the S&P is down 2.6 percent, and the Nasdaq composite is down 2.3 percent as of Wednesday's close.

Not so good, huh? But not so bad really, from an historical perspective.

October is typically a mixed month for the markets, what the Stock Trader's Almanac refers to as both as a "jinx" month and a "bear killer."

October's a "jinx" month because of crashes, such as particularly famous ones in 1929 and 1987. But it's also a "bear killer" because what starts out badly often ends up just fine, leading into the market's traditional "Santa Claus" rally in November and December.

Since 1950, the Dow has gained an average of 0.6 percent in the month, and the S&P gained 0.9 percent, according to the Almanac. Since its inception in 1971, the Nasdaq has on average gained 0.5 percent in the month.

But often, the market will bottom in mid-to-late October, paving the way for the year-end rally.

November is typically the second best month of the year for the S&P, after December. And those months are among the best for the Dow and the Nasdaq.

Why the year-end strength? A combination of factors, such as year-end portfolio rebalancing, a rush of retirement money into the market, investor relief that third-quarter earnings are over, and optimism about holiday retail sales.

So far, the market looks like it's shaping up for the typical October correction, said Jeffrey Hirsch, editor-in-chief of the Stock Trader's Almanac.

According to technical indicators that the Almanac's crew looks at, the market is probably due to lose another 5 to 7 percent this month, which would put the market at its lowest in about a year.

"That should set us up for the fourth quarter rally we are all anxious for," he said.

Last year, stocks had a tough October as investors worried about a slowing economy, rising interest rates, surging oil prices and the possibility that the presidential election might hit the same roadblock it did in 2000.

But oil prices began to fall, the economy chugged along at a solid clip, the Fed's rate hikes remained measured and the election went smoothly. Stocks rallied into the close of 2004.

Substitute "rampant inflation fears" for "undecided election fears" and this year isn't looking all that different.

However, while the market may not miss out on the typical year-end run, the problems that have weighed on stocks aren't likely to disappear anytime soon.

"I don't think these heavy issues will threaten the end of year rally, but I don't think 2005 and 2006 are going to be great," said Hirsch.