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Pause defies upward trend

By Neville Bennett

Friday 31st October 2003

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US equity markets have stalled recently. This is a response to many factors, including rising interest rates, doubts about the sustainability of the economic recovery and a caution about extrapolating good earnings growth into the future.

Investors are not exuberant. The steep profit falls of 2000-01 and the implosion of stock values have taught a generation that markets can rise and fall.

However, this "wall of worry" may be eroded if earnings remain high and the recovery remains staunch. The signs are optimistic and continued success should attract more sidelined cash into the market.

US growth is expected to be 6% for the third quarter. Rather than be jubilant, markets sold off.

Can growth continue? There is a strong chance interest rates will start tightening.

Moreover, the tremendous boost of tax cuts, record low interest rates and mortgage rates has a diminishing effect.

However, imports are down, and both government and business spending are robust. Inventory has been low and restocking is strong. A 3% annual growth rate seems assured.

Other countries are also going well, especially China and Australia. Commodity prices are rising so the outlook is good.

US Treasury Secretary John Snow says that even ''if interest moves higher, the recovery will not be in jeopardy."

Mortgage refinancing has kept consumer spending solid, so higher interest rates indicate a stronger economy.

The fiscal deficit is much smaller than anticipated, because government revenues are benefiting from high economic activity and profitability. A lower dollar brought benefits to exports.

A US competitiveness has a downside for the European Union, which is beginning to lament a high euro. German growth remains modest because it is a major exporter and the low dollar could undermine the bourse.

The UK is different. The Bank of England has minuted its belief it made a mistake in cutting rates as the twin consumer and housing boom are unsustainable. Since July, borrowing has reached a record high and inflation is a real prospect.

US bond yields have increased but worries have been misplaced that they would impact on mortgage rates and thereby slow housing demand.

US housing activity remains strong and could perhaps withstand higher mortgage rates.

A higher 10-year bond yield, which seems headed for 5.3%, could act as a brake on equities as investors switch. The higher cost of money increases business costs and weakens profits.

Several studies indicate equities could continue their bull run, despite rising bond yields, provided earnings increase.

Another essential proviso is that US money growth (M2) does not slip below 6% or so a year.

A fall in monetary aggregates would be a strong sign that policy was not loose enough to support GDP growth and further equity gains.

More gains, especially in cyclical stocks, are in prospect, as equities are attractive relative to bonds, and earnings forecasts have improved. There is significant operating leverage in the pick-up in government revenue.

Business confidence may increase when it accepts the fact that revenue marks a strong economy.

While the future cannot be predicted with certainty, it is apparent that an up-trend exists. It will persist if the market continues to finish at higher highs and establishes higher lows.

These indicate that it is breaking through resistance lines and finding stronger supports (such as increasing commitment of funds and fewer withdrawals).

The Nasdaq has been strong, reaching 1880 last week. While some observers believe it is over-bought, it has set high lows and has broken many resistance lines.

The Dow is also rugged, breaking strong resistance at 9400 and it now seems set to breach 10,000.

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