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The US stock market is still suffering from a split personality – and the difference between its two faces is now more marked than ever. While investment continues to pour into internet companies, the giants of the old economy are struggling to keep up.
Most economists take a broadly positive view of the US economy as a whole, but market watchers say there are clear signs that a downturn in the stockmarket is imminent. Not only should the Federal Reserve’s increasingly tight monetary policy pour cold water on market sentiment in the next few months, but technical factors also point to an impending downwards correction, strategists said.
Merrill Lynch’s chief market analyst Richard McCabe points out that the market’s two-way trend of recent history became even more pronounced in early February. In one week, for example, the technology-dominated Nasdaq Composite Index rose 3.6% while the Dow Jones Industrial Average fell 4.9% in the same period.
HSBC global strategist Bill O’Neill agrees that the dichotomy between the Dow and the Nasdaq is remarkable. Not only is the high concentration of technology stocks listed on Nasdaq a factor in the opposing fortunes of the two benchmarks, he says, but the Nasdaq index could also be affected by the large number of foreign stocks listed.
As much as a third of the Nasdaq’s performance this year could be due to foreign stocks, he says. However, US stocks on the whole, are set to slide, he says.
“I think the market is heading down,” he says. “Six months from now we will be at the peak of interest rate expectations,” he adds. July will be the most torrid time for equities, with US interest rates probably rising half a percentage point from current levels, he predicts.
“Broadly, stocks will stand at around 15% below current levels in six months’ time”, says O’Neill, adding; “But in the second half of the year, rates are likely to start easing again, and this will probably prompt some recovery in the market. Traditional defensive sectors such as utilities and consumer goods would be in favour in this type of environment.”
But despite their current popularity among buyers, technology stocks would not be immune to the coming correction. From a chart point of view, Richard McCabe notes that in the last six weeks the Nasdaq Composite Index’s advance has become much more ragged or choppy in contrast to its parabolic run-up in the fourth quarter of 1999.
“This change suggests that even this powerhouse index may be losing momentum, a condition which is often the forerunner of a ‘top’ formation and subsequent trend reversal to the downside,” he says, continuing: “Many of the leading large-cap technology stocks which drove the index higher last year have recently suffered sharp falls, and this could be a prelude to a more general decline in technology stocks over the coming months.”
But if this happens, it could be good for the market in the longer term. It would deflate bullish sentiment and speculative exuberance to a healthier lower level, says McCabe, noting that a technology IPO recently rose six-fold from its offering price during subsequent trading on the same day.
Though the equities market is likely to weaken, the US economic fundamentals are seen as sound.
“We’re positive on the economy,” says Nick Bennenbroek, international economist at Deutsche Bank, forecasting 4% GDP growth for the first quarter and 3.5% in the following quarter.
“But even so, we are not seeing a lot of inflation outside oil price-induced increases,” he adds. Core inflation in the US was running at just 1.9 % at the end of 1999. Economists said inflation was at a reasonably low level given high productivity.
Further increases in the cost of credit are seen as inevitable. “But we think (the Fed) will take a gradualist approach to tightening,” says Bennenbroek. “We would expect them to move in steps of a quarter of a percentage point as opposed to half points,” he says, predicting a quarter point rise in March followed by an identical increase in May.
The Fed funds rate, which is currently 5.75%, is likely to rise to 6.25% by the end of the year, according to Deutsche Bank forecasts.
Bank Julius Baer’s Dick Howard only expects the Fed to raise interest rates once more in March by another quarter point. This should be enough to slow the economy to growth rates of between three and 3.5%, which would satisfy the central bankers.
Howard believes the Fed is increasingly accepting that something fundamental has changed in the US economy on the productivity front, meaning the economy can now endure higher growth rates than two to 2.5% without triggering inflation.
“But even if the Fed were to take this view, it remains uncertain whether the stockmarket would take such growth rates in its stride,” he says.
In the US government bond market, Howard sees the supply situation tightening with the US Treasury set to retire a net $120bn (E120bn) of debt this year throughout the curve.
This would make the US Treasury market look reasonably attractive compared to Europe and extremely attractive when seen against Japan, he says.

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