street sense
What's Scaring the Stock Market?
Commentators point to a rise in interest rates, but other, longer-term factors are cause for concern.
By Jerry Helzner

After delivering a strong performance in 2003, the stock market spent most of the first half of 2004 in a funk that left investors shaking their heads.

The months leading up to a presidential election are traditionally good for stocks. The rationale for strong performance is that the political party in power will do everything possible to fuel economic growth just prior to the election. By all accounts, the Bush administration is doing just that through its policy of tax cuts and massive government spending. But this year, stocks aren't responding positively.

It's Not Just Higher Rates

As the major stock averages continued to falter in mid-July, market commentators had but one explanation for the decline.

Though ascribing the market slump to fear of higher rates seems to be the simplest explanation, in this column I'll cite three other key factors that are helping to keep stocks on the defensive.

First, it's been clear all along that the Federal Reserve's action in reducing interest rates to 40-year lows was designed to be a temporary stimulus to help jump-start a weak economy.

And the strategy worked, particularly in lowering mortgage rates to the point where homeowners could refinance their debt and put significant additional money in their pockets each month. Interest rate reductions created many first-time homeowners and encouraged purchase of autos and other big-ticket items. Business investment also benefited from years of low rates.

But the real point is that the exceptionally low interest rates we've seen for the past few years had to eventually come to an end.

The somewhat higher interest rates we expect to see over the next year or two (with the prime rate moving to the 5% range) are in line with interest rates that we've seen during economic expansions. And these rates have never acted as a brake on the stock market before.

Look at Other Factors

So the prospect of somewhat higher interest rates isn't what's really scaring the stock market. Instead, let's look at other factors that have investors nervous:

"Baby boomers" are turning into retirees. The huge cohort of post-war babies are rapidly approaching the age of 60. The millions of baby boomers who have worked and paid their taxes for the last 40 years are about to collect on their Social Security and Medicare entitlements. With fewer workers supporting more retirees, the United States is rapidly approaching a financial crossroads. If retiree benefits are to be maintained at current levels, the remaining workers will have to absorb the cost in tax increases. If retirement benefits are cut, the standard of living of American seniors will drop. In any case, future decisions regarding Social Security and Medicare are a concern to investors.

Increasing worldwide competition. America's manufacturing base is being eroded as more countries can make what we make -- and make it cheaper. As these emerging countries grow, they're also competing for scarce resources such as energy and steel. Global competition makes it tougher for American companies and workers to prosper.

Iraq and terrorism. Bad news on these fronts can send the market into a dive. Investors are wary.

Higher rates is an easy explanation for the stock market's malaise. It may not be the right one.

Ophthalmology Management Senior Associate Editor Jerry Helzner has written more than 50 articles on stock investing for Barron's. He has been a regular stock market columnist for other business publications and was a member of the equity research department of a major regional brokerage firm. E-mail your stock market questions to him at helznergi@boucher1.com.