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Cappiello Sees Stock Rally Once Interest Rates Stabilize

It was easy to be bearish on the US stock market as 2005 drew to a close. An unprecedented wave of bad weather had wreaked devastation on the Gulf Coast. Soaring oil prices were squeezing consumers and threatening to ignite inflation. Housing prices in some parts of the country were so high they were prompting fears of a bubble. The Federal Reserve continued to push interest rates higher, and the federal deficit, to some minds, had swollen out of control. Certainly the market's performance through the first 10 months of 2005 was no cause for celebration; through October 20, the Standard & Poor's 500 stock index was down about 2.8 percent for the year, the NASDAQ Composite off nearly five percent.

But Frank Cappiello, Chairman and Managing Director of investment advisory firm Montgomery Brothers, Cappiello LLC, was bullish—and saw his optimism justified. A year-end rally left the S&P 500 up 3 percent for 2005. Speaking at the SVIA Forum, the prominent market analyst cited a litany of reasons to show why investors shouldn't be pessimistic. While Hurricanes Katrina and Rita caused an estimated $150 billion to $200 billion in damages to the Gulf Coast, Cappiello said, cash flowing into the area to aid in its recovery insures that those disasters, despite the human tragedy, would prove nothing more than a hiccup for the economy. History supports the argument, he said, noting that three months after Hurricanes Andrew in 1992, Hugo in 1998, and Charles and Ivan in 2004, most of the economic impact of those storms had been mitigated, and a year later, was virtually nil. (In fact, a week after Cappiello spoke, the U.S. Commerce Department reported that the nation's gross domestic product grew at a strong seasonably adjusted 3.8 percent annual rate during the third quarter, despite the impact of Hurricanes Katrina and Rita.) History also suggests, Cappiello said, that any housing bubble that might be developing in this country is regional, not national, and could be cured "without a lot of stress." He also noted that on a national level, housing prices have risen every year since 1960, illustrating the odds against a national housing market crash.

On the oil front, Cappiello said, rising prices have made drilling for alternate sources of crude--such as those trapped in the tar sands of Canada--more economically viable, which will help to temper prices going forward; he expects crude prices to stabilize in the neighborhood of $50 to $55 a barrel over the next 12 months.

Cappiello also said that higher energy prices and rising interest rates have dampened the mood of the American consumer, but they haven't sent them running. Cappiello said he expects retail sales to be down by a manageable five percent during the always important Christmas shopping season this year. At the same time, business executives remain confident as ample supplies of cash are on hand to fuel investment in new opportunities, such as mergers, when they present themselves. One reason for their optimism, he added, is that corporate profits have risen for seven straight quarters, a trend he sees continuing for the foreseeable future.

On top of all this, Cappiello added, stock prices aren't terribly high right now relative to corporate profits, with the S&P 500 valued at just over 14 times the per-share earnings of its component companies.

The key to the stock market's performance from here out, Cappiello said, will be the Federal Reserve Board's interest rate actions. Over the past year and a half, the Fed has raised the federal funds rate-the rate at which banks lend balances at the Federal Reserve to other banks--to four percent from one percent. Cappiello said that while bumping the rate higher could put the US economy at risk, if not of a recession, then at least a downturn. He believes the Fed won't push rates substantially higher. Once short-term rates have stabilized, he added, the stock market should be poised for a significant rally, something he said he hoped might happen as soon as 2006. In fact, he said investors can look for the Dow Jones Industrial Average, which sat at 10,344.98 at the close of trading on October 26, to be above 11,000 sometime in the first quarter of 2006.

Cappiello is less bullish on corporate bonds than he is on stocks, arguing that the outlook for that market changed for the worse with the bankruptcy filing of auto parts maker Delphi Corp. Although executives at ailing General Motors Corp. have denied considering bankruptcy as a solution to that company's financial woes, Cappiello pegged the chances of a Chapter 11 filing by GM at about 30 percent. "There is greater risk in the corporate bond market now than there was last year," Cappiello said, adding that the failure of commodities broker Refco Inc. decimated the value of its bonds. It also illustrated that there are dangers in the corporate bond market right now. Cappiello said he was more favorably disposed both to US Treasury bonds and to foreign sovereign bonds, noting that the latter can also provide investors with a hedge against the U.S. dollar.

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