Market Outlook – December 14, 2004(A)

As the elections came down to the wire in late October the market began to stir from its slumbers, anticipating a resolution of the contest and of the uncertainty surrounding it. Once the results were in buying began in earnest and the market moved straight up for a month. From a pre-election low on October 25 through the post-election high on December 1, the S&P 500 gained 9% while the more volatile NASDAQ rose 12%, gains that put both indices up modestly for the year.
After the election President Bush was quick to throw the market a bone in the form of his proposed privatization of Social Security, a move that would unlock vast future demand for stocks. We won’t go into the plan’s many flaws here, but there’s no denying its potential impact on stocks from a pure supply/demand perspective.
The greater boon to stocks has been the precipitous decline in oil prices, one that has OPEC scrambling to cut supply only weeks after pledging to boost it. From a high of $55 a barrel the price of oil has plummeted nearly 30% in two months to the $40 area. As we noted last time, the spike in oil prices was driven in no small part by pure financial speculation–a fickle source of demand that can turn into supply (selling) on a dime. Which is precisely what happened.
With the uncertainty of the election behind us and oil prices returning to more reasonable levels, two market negatives were resolved. As stocks remained significantly undervalued relative to bonds, the market responded by bidding up shares accordingly. What remains to be seen is whether this reduced uncertainty prompts corporate America to deploy its vast cash horde in new hiring and capital investment, something it has done only sparingly thus far in the recovery.
If hiring and capital investment pick up, corporate earnings expectations will accelerate and that would boost potential returns from stocks. If hiring doesn’t pick up we would expect economic growth to continue at its current 3%-4% pace. On that scenario stocks should still deliver positive returns in excess of those available from bonds based on their relative valuation.
As a parting comment we’ll note that the sudden ubiquity of panicky headlines on the falling US dollar suggests that the worst of this trend may be behind us. It’s a truism of markets that by the time everybody’s scared about something, the worst of it is already priced in (see the headlines on oil prices from two months ago). That said, we don’t dismiss the possibility of a sudden dramatic decline in the dollar, but we think it rather unlikely.
The argument for a plunging dollar rests on the assumption that the largest foreign holders of US dollars–Japan and China, in that order–will lose their appetite for our currency and begin to sell off their US dollar holdings. Doing this would indeed depress the dollar and could do so quite dramatically. But because Japan’s and China’s dollar holdings are so large, they could sell only a small portion of their total position. That would be enough to drive down the dollar–and with it the value of their remaining vast dollar holdings. For Japan and China to sell dollars because they fear a further decline in the currency would be like pouring kerosene on a fire to put it out.
So while the dollar may decline further, it is likely to do so gradually. Such a gradual decline shifts demand toward US goods and away from foreign goods, which helps gradually correct the very trade imbalance that has driven the dollar down in the first place. This needn’t be a disruptive process and it’s the disruption that concerns investors.