Stocks finished the third quarter on a positive note. All of the major averages posted moderate advances last week. The Nasdaq Composite led the way with a 1.6% return during this time. The Dow Jones Industrial Average and the S&P 500 followed closely behind with gains of 1.4% and 1.1%, respectively.
Earnings season kicks off later this week, allowing investors their first glimpse into how higher energy prices and the hurricanes have affected businesses. Next week there will be a full slate of earnings news and the picture will become even clearer. Today we learned the construction industry was experiencing its highest level of activity in history during August. This was before the hurricanes hit. The reconstruction in the Gulf region will undoubtedly spur the industry to new records. In addition, the Institute for Supply Management (ISM) reported that the manufacturing sector is firing on all cylinders and has not seen any notable slowdown as a result of higher energy costs or weather-related disruptions.
While the recent spike in energy prices is not stopping the economy from moving forward, its effects are showing up in other areas. The ISM report also showed a spike in the cost of raw materials used to produce manufactured goods. This inflation will be absorbed by the manufacturer to the detriment of profits; the consumer will be asked to pay more, thereby hurting demand; or some combination of the two. In addition, one of the Federal Reserve`s mandates is price stability, which means the threat of inflation will also keep the Fed vigilant in raising interest rates.
These factors will prevent stock prices from getting ahead of themselves, but still allow for appreciation in-line with earnings growth rates. Currently, corporate earnings growth in 2006 is expected to be above the historical rate of expansion, which would mean solid stock market returns should growth expectations be met and valuations remain constant. Insight expects energy prices to be lower next year, which would add to the overall growth of the economy.
Stock market valuations have dropped steadily throughout the course of 2005, as prices have remained essentially unchanged during which time earnings growth has been robust. You would have to go back to 1995 to find similar valuations on the S&P 500. And you would have to go back to 1990 for similar valuations based on 2006 expected earnings. Both of these periods proved to be excellent buying opportunities. While similar results may not be achieved in the months ahead, clearly the risk-versus-reward parameters are tilted solidly in investors` favor.
This article highlights the commentary of Jim Collins for the Zacks.com audience. Jim Collins provides insightful analysis, market commentary, and favorite recommendations on a timely basis in "OTC Insight" newsletter. Try it free for 30 days and see if you can improve your investment performance. Learn more about "OTC Insight" and 30-Day Free Trial. And get immediate access to current issues and special reports. Click here now.
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