Delving into the Conventional Wisdom

There are two reasons the market is down so far this year; energy and interest rates. The question we need to ask ourselves is “Are the stock market reactions we are seeing correct?” Since the market is mostly psychological, investors need to take a deep breathe and focus on reality, not simply psychology or perception.

Stocks are being held down by underperforming names in the financial services and consumer discretionary sectors. Together, those 2 areas represent 31% of the S&P 500. That’s a huge chunk. Regardless of how strong energy, materials, and health care stocks act in times of higher interest rates and fears of an economic slowdown, they won’t be able to carry the market on their shoulders. Why not? Energy and materials are only 13% of the market. Health care is another 13%, but that only gets us to 26%, less than the 31% of weakness we need to offset.

The weakness in financial services is real and very much warranted. Banks are going to struggle with a flat yield curve. If you were running a bank and your borrowing costs were risng faster than the lending rates you could charge, your profit margin would be squeezed. No doubt about it. Until the Fed is ready to stop, financials are not right here, so let’s hope once Greenspan is gone in early 2006 that rates stabilize.

Conversely, the sell-off in consumer discretionary sectors is a little less warranted, in my opinion. As gas prices have gone from $2 a gallon to $3 a gallon, drivers will need an extra $60 per month to fill up their cars if they have a 15 gallon tank and fill up once a week. The question we need to ask is, where will that $60 come from? I don’t doubt that it will be taken out of another area of one’s personal budget, but where? It won’t come out of every other place.

One of the conclusions I’ve come to is that it won’t come out of food expenditures as much as the restaurant stocks are telling us. I still think the trend toward eating out, not cooking at home, is here to stay, regardless of gas prices. Families might not go out and spend a lot of money on food, but they should still eat out at a reasonable price. With major restaurant chain share prices at 52-week lows, that’s an area I would strongly consider buying as prices continue falling.

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2 Thoughts on “Delving into the Conventional Wisdom

  1. SiamTwin on October 13, 2005 at 5:54 AM said:

    a while back you quite sensibly pointed out that consumer spending probably won’t be dented much by high energy prices alone, but that it could be hit hard by higher mortgage rates. with the 10 year treasury inching back up toward 4.5%, could that be really what the market is worried about here?

  2. Chad Brand on October 13, 2005 at 7:25 AM said:

    True, it’s a combination of all those things. Still, mortgage rates increasing by 50bp, or even 100bp, won’t be disasterous. I don’t think the 10-year will go above 5% any time soon.

    Like is the case quite often, I think the current sell-off is quite overdone. I think upcoming Q3 earnings reports will do some good in showing that things aren’t as bad as the market would have you believe, albeit consumer spending won’t be brisk either.

    The market might not react right away by giving back some of the recent losses, but as investors, seeing decent numbers would comfort even more those who have been buying this correction, myself included.

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