October 17, 2006
One has to wonder how the Dow Jones Industrials can continue to climb towards the record high close during much of the third quarter with so much chaos going on around the world. How could the Dow Jones Industrial Average eclipse an all time high with the Iraq War combined with the Iranian and North Korean nuclear threats grabbing all of the headlines? It would seem that the markets should be selling off on negative news, not going higher, right? There are several factors as to why certain indices are doing well during these difficult times. First, we have seen the price of oil drop precipitously in this past quarter. We have also seen the Federal Reserve hold up a caution sign as they wait to see what the future holds for inflation. More specifically, the Dow Jones and S&P 500 indices had a great third quarter due to the shift from smaller stocks to larger stocks.
In my opinion, it is the price of oil dropping this past quarter that had the biggest impact on the Dow and S&P 500’s positive returns. The theory is that as oil drops in price, consumers have more money to spend elsewhere in the economy. The second way the oil prices are helping stocks is through the cost of goods sold – with oil down, transportation costs are lower. Bigger demand and lower costs of good sold increases the likelihood of higher corporate profits. However, do not sell your hybrid cars just yet! While some believe oil could still go down in the short-term, over the long-term many analysts believe the price of oil will go higher.
As I mentioned in the second quarter’s client letter, the Federal Reserve’s interest rate pause is helping mortgage rates stay low. This is currently helping the housing industry in that more people are able to afford mortgages and some are refinancing at lower rates for longer terms. It remains to be seen whether the lower interest rates will keep the housing market from falling further or if an over-supply of homes in certain cities around the country will force the housing industry lower. If rates go up and the over-supply continues, real estate prices will continue to fall.
As I mentioned above, larger stocks outperformed smaller stocks in the third quarter of 2006. Many analysts believe this is a sign of a slowing economy. It is not uncommon for investors to purchase large-cap companies when they believe the economy will start to slow. Large corporations tend to be more diversified across different sectors and can withstand a slower economy better than smaller, more focused companies. It is in this light that we will continue to emphasize large-company stocks within your portfolios.;
Sincerely,
William A. Bullock