Why Dow May Be Off the Money

By Tom Petruno and Josh Friedman

Dec. 31, 2005 12 AM PT

Times Staff Writers

The stock market closed out 2005 on a down note Friday, leaving the Dow Jones industrial average with its first annual loss since 2002.

On Wall Street, the year-end slump triggered fresh debate: Is the Dow’s red ink sending a warning about the U.S. economy in the new year, or is it obscuring an upbeat outlook?

The Dow’s 67.32-point drop Friday, to 10,717.50, left the market’s best-known index with a decline of 0.6% for 2005.

Because the trend in the market often foretells turning points in the economy, the Dow’s troubles raise concerns that investors are reluctant to buy stocks because they fear the U.S. is headed for a sharp slowdown or an outright recession.

Another significant market shift in recent weeks also has boosted recession fears: Long-term interest rates on Treasury bonds have fallen below shorter-term rates. That has been a relatively rare occurrence historically, and when it has happened it often has signaled a weaker economy ahead.

But many investment professionals remain bullish about 2006. They expect that the Federal Reserve soon will stop tightening credit and that energy prices won’t rise much more, giving the economy room to run.

“We think the catalyst for further stock market gains will be what it has been: global and U.S. economic growth chronically stronger and more durable than most anticipated,” said James Paulsen, chief investment strategist at Wells Capital Management in Minneapolis.

As for the Dow, many believe the 109-year-old index of 30 large, blue-chip companies hasn’t been an accurate barometer of the economy or the broader stock market for the last two years.

Although the Dow lost ground in 2005, the average New York Stock Exchange stock was up nearly 7%. That also was the gain of the average U.S. stock mutual fund, according to fund tracker Morningstar Inc.

Shares of many smaller companies scored even better returns, which weren’t necessarily reflected in the modest yearly gains posted by the broad Nasdaq composite index or the Standard & Poor’s 500.

Jim Peoples, 61, a retired healthcare executive in Agoura Hills, estimated that his portfolio rose about 10% this year, thanks to healthy advances in smaller stocks and in such market sectors as energy.

“I’ve definitely done better than the Dow and the other indexes,” Peoples said.

The Dow also was the weakest of major stock indexes in 2004, when it added just 3.2%. Despite that poor performance, the economy expanded at a brisk pace in 2005, and corporate earnings grew at a double-digit rate, on average.

The Dow has struggled as 16 of its 30 stocks fell this year.

General Motors Corp.’s shares, for example, plummeted 51%, to their lowest level since 1982, as high gasoline prices hammered GM’s sales of highly profitable sport utility vehicles.

Pfizer Inc. slumped 13% for the year as it faced rising competition for some of its key drugs.

Wal-Mart Stores Inc.’s shares declined for a second straight year, losing 11%, as investors worried about its long-term growth potential.

By contrast, shares of Whole Foods Market Inc., a fast-growing natural-foods supermarket chain that is not part of the Dow, rocketed 62% this year, reaching a record high of $79.10 this week.

Since 1999, many investors have been turning away from the stocks of mature, blue-chip firms in favor of the shares of smaller companies that have stronger growth prospects, analysts note.

“People seem to be finding more opportunities in smaller and mid-size companies,” said John Carey, manager of the Pioneer Fund in Boston. “A lot of industries are going through tremendous change,” he said, which may hurt established companies while opening up opportunities for younger firms.

U.S. investors also have been turning more to foreign stocks. Stellar gains in many non-U.S. markets in 2005 belie the idea that a global economic slowdown might loom, experts say.

Japan’s main stock market index rocketed 40% this year, its biggest advance since 1986, as the Japanese economy showed more signs of a sustained rebound in growth after struggling for much of the last decade.

Most European stock markets rose more than 20% this year. In Asia, most markets outperformed U.S. stocks, as China’s economic boom stoked growth across the region.

Michael Metz, investment strategist at money manager Oppenheimer Holdings in New York, said the powerful rallies in foreign stock markets suggested that investors were expecting stronger consumer and business spending abroad than in the United States in 2006.

He doesn’t fault their logic, saying that U.S. consumers may be overstretched financially, and that many have become too reliant on tapping their home equity to maintain their spending. If the housing market weakens in 2006, it could drag down the broader economy, especially if energy costs stay high, Metz said.

“I’m worried about the consumer,” he said. “Is this going to be a hard landing or a soft landing for them?”

The recent trend in U.S. interest rates also has pointed to investors’ concern about the economy’s outlook.

The interest rate, or yield, on the 10-year Treasury note -- a benchmark for other long-term rates, such as for mortgages -- ended the year at 4.39%.

By contrast, the yield on the two-year Treasury note ended at 4.4%.

Normally, longer-term bonds pay more in interest than shorter-term issues to compensate investors for the risk of tying up their money for an extended period.

When long- and short-term interest rates “invert,” it often is a sign that bond investors believe the economy will slow -- so they’re locking in long-term yields in anticipation that rates overall soon will level off or even head lower.

The last time short-term rates were above long-term rates was in the second half of 2000. By the spring of 2001 the U.S. economy had fallen into recession.

This time, however, many analysts believe that long-term bond yields are being pulled down by special factors unrelated to the economy’s fundamentals. One such factor may be the ravenous appetite of foreign investors for U.S. bonds, which pay more in interest than similar securities in Europe and Asia.

Fed Chairman Alan Greenspan has said that the central bank won’t necessarily assume that an interest rate inversion is sending the same economic warning that it has in the past.

Some Wall Street veterans say they’re trusting other market indicators that suggest that the U.S. economic outlook remains positive.

The Dow transportation stock index, which tracks shares of 20 major railroads, airlines and trucking firms, jumped 10.5% in 2005 and hit an all-time high Dec. 23.

Historically, strength in that index has signaled optimism about business activity because the fortunes of transportation companies are directly tied to the economy’s overall health.

With the transport index near a record, asked Sam Stovall, investment strategist at Standard & Poor’s in New York, “how can we be worried about the economy?”

BEGIN TEXT OF INFOBOX

How key stock indexes fared

Price changes of major indexes in 2005

Dow utilities: +21.0%

S&P; mid-size stocks: +11.3%

Dow transports: +10.5%

NYSE composite: +7.0%

S&P; small stocks: +6.7%

Bloomberg REITs*: +6.0%

Russell 2,000: +3.3%

S&P; 500: +3.0%

Nasdaq composite: +1.4%