Rate Worries Weigh On Stocks


U.S. stocks have been choppy, with mostly good economic news countered by worries about rising short-term interest rates. Higher rates would benefit financials and would likely mean the U.S. economy is on firmer ground. But the transition to a market not fueled by low interest rates could get messy. For now, with the Dow Theory in the bearish camp, we're keeping about 20% of our equity portfolios in a short-term bond fund.

Leadership vacuum

If this year's leading sectors (consumer staples, energy, materials, and utilities) slump, the market will likely need new leadership to avoid a full-blown correction. Eventually, we expect improvement in the outlook for corporate profits to rekindle interest in such growth-oriented sectors as consumer discretionary, financials, industrials, and technology. But with the timing of such a revival highly uncertain, the stock market's ability to weather interest-rate worries will be crucial in the near term.

The defensive consumer-staples and utilities sectors have come under pressure since early May, reflecting profit-taking and valuation concerns. Both sectors trade at unusually rich price/earnings ratios relative to other sectors, reflecting investors' desire for steady results and steady dividends. Many justify the rich valuations of these bond-like sectors by comparing them to bond yields, so higher interest rates could put pressure on P/E ratios.

The energy and materials sectors, which have rebounded sharply from multiyear lows reached in January and February, are also unusually expensive. Both sectors tend to suffer when the U.S. dollar strengthens, and the dollar tends to rise when the U.S. Federal Reserve raises rates faster than other central banks.


In the recently released minutes to its meeting on April 26-27, the Federal Reserve said "it likely would be appropriate" to increase the federal funds rate in June if economic data showed growth picking up. Until recently, interest-rate futures suggested little chance of an increase in June.

With expectations for interest rates rising, the need for new stock-market leadership should intensify. For now, we're emphasizing attractively valued growers like Citrix Systems ($83; CTXS), LKQ ($32; LKQ), and Southwest Airlines ($43; LUV).

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