The end of a quarter is often a time for reflection, as investors — particularly institutions, who are measured by their quarterly returns — look back to see where they've been, and ahead at what they can expect for the coming quarter or two. Looking back, they see a rally like the major market indexes haven't seen since the days of the bad old bubble. And looking forward? Well, they can't really see anything looking forward, because their eyes are screwed shut, as they pray with desperate hope to the gods of the market: Please, let there be some follow-through this time.
The past quarter was certainly a barn-burner for most of the indexes, when compared with some of the quarters the markets have seen over the past few years. The Nasdaq rocketed higher by 21 per cent — its best performance since the final quarter of 2001, when the markets saw a sharp rebound after the Sept. 11 terrorist attacks on New York and Washington. The Dow Jones index also had its best quarter since the latter part of 2001, rising 12.4 per cent, while the Standard & Poor's 500 index had its best performance since the last quarter of 1998, climbing 15 per cent.
It's that last date that might give some investors pause, even as they feel the almost insatiable urge to give in to their inner bull. The year 1998 was when the tech-fueled rally was under a full head of steam, one that would push the indexes ahead by astronomical amounts over the following two years. And if you strip out the fourth quarter of 2001 as an anomaly as a result of Sept. 11, the latest quarter was also the best for both the Dow Jones and the Nasdaq market index since the final quarter of 1998, when the Dow rose by close to 17 per cent and the Nasdaq rose almost 30 per cent.
The quarter just ended seems even more remarkable when you consider that the first couple of months of the year saw the major indexes slide lower as a result of concern about the fate of the U.S.-led war with Iraq. From the lows of March, the S&P 500 is up by more than 25 per cent, the Dow is up by almost 25 per cent and the Nasdaq has climbed by more than 30 per cent. That's the most bullish performance the three major market indexes have seen in a good long time — but the question remains as to what is driving it. Relief over the end of the war? President George W. Bush's tax cut package? The 13th consecutive rate cut by the Federal Reserve? The sliding value of the U.S. dollar?
The most troubling thing about the quarter just ended is how wide the gap is between the performance of the major indexes — including the tech-heavy Nasdaq, the market all the pundits said would never be a leader in the next rally - and the actual performance of the U.S. economy. To judge by the market's rise, you would expect to see factory orders booming, companies hiring new workers and boosting profit targets, putting their money where the market's mouth is. But there has been little sign of that. On Tuesday, the Institute for Supply Management survey came in below 50 again, a sign that the crucial manufacturing sector is still shrinking rather than growing.
In fact, the best that most economic reports have been able to say is that the U.S. economy is "stabilizing." The profit boost some companies have managed to produce has come almost entirely from cost-cutting, and that has meant layoffs and cutbacks. Those in turn have kept the unemployment level high and industrial demand levels weak. The best that Fed chairman Alan Greenspan had to say about the current state of the economy is that it has shown "resilience" and that he is "cautiously optimistic." Despite interest rates that are lower than they have been in 45 years, and the stimulative effect of a lower U.S. dollar, the industrial and manufacturing parts of the U.S. economy — its traditional engine — are still operating at only 75 per cent of their capacity.
And yet, stock prices aren't just discounting an increase in profits, but a substantial surge across the board. Some technology stocks such as Yahoo, Amazon and eBay are selling at multiples that haven't been seen in several years — 100 times or more — and Dow stocks such as IBM, General Electric, J.P. Morgan and Home Depot are close to 52-week highs. The bulls are hoping the market is acting as a forecasting device, and that these share prices are anticipating a rebound. But what if one doesn't occur? The market forecast a strong rebound last year too, and the year before that, and one never arrived. And the markets aren't likely to be happy with just a tepid recovery.
In other words, as we move out of one of the best quarters in recent memory, the risks to the downside outweigh the risks to the upside.
E-mail Mathew Ingram at mingram@globeandmail.ca
Mathew Ingram's past columns and a short biography are here
Look for exclusive Mathew Ingram commentary at GlobeInvestorGold
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