Sideways markets don't have to sideline investors

This was supposed to be a pretty good year for US stocks, especially since some of the optimistic predictions by market experts turned out to be true.

"We had a forecast that corporate earnings growth would be good, which it has been," says Jeffrey Applegate, chief investment officer at Fiduciary Trust Company International in New York. "We predicted that the Fed would start gradual tightening, which it has. We also predicted that inflation would accelerate, but only modestly, and that's continuing to be the case."

So why does the stock market seem unable to gather steam, moving sideways more often than it marches forward or falls back? Since the beginning of the year, the Standard & Poor's 500 stock index has declined about 1.2 percent. Through the end of July, the return of the S&P 500 was close to zero. "Any time you're in a trading range with very little volatility and not a lot of opportunity, people wonder what is going to be the catalyst to push you out of a range in either direction," says Liz Ann Sonders, chief investment strategist at Charles Schwab & Co.

Ms. Sonders sees a few reasons for the market's lack of direction:

First, because investors don't know what - if anything - might happen on the terrorism front, they have built a "terrorism premium" into the market. If the Republican convention, the Olympics, and the November election pass with no domestic attack, the market's mood may improve, she believes.

Then, there's election results. By this time in the election cycle, Sonders notes, investors usually have a pretty fair idea of who will win. But with the electorate so evenly divided, the market isn't sure who the victor will be.

A need to know

"We don't know who's going to win," agrees Gina Sanchez, a member of the portfolio management team for the American Century Strategic Asset Allocation Funds. "The market can deal with either Bush or Kerry, but it kind of has to know so it can get over that." For example, she says, whoever occupies the White House next year will have a lot to say about tax policy affecting business. "If you're running a business, you're not going to make a major decision until you know the repercussions of that decision," Ms. Sanchez notes.

Finally, longer-term interest rates have been rising in anticipation of moves by the Federal Reserve Board to raise short-term rates. Because they increase borrowing costs and create more competition for stocks, higher interest rates can put a damper on stock prices.

But none of these factors has had the impact of rising oil prices. "We did not expect oil prices to be up nearly 50 percent year-to-date, which they are," Mr. Applegate says. "The market's really been struggling over that."

Higher oil prices have a direct effect on consumer spending and sentiment, notes Scott Brayman, portfolio manager of the Sentinel Small Company Fund in Montpelier, Vt. When people have to spend more on gasoline for their cars - and more on heating oil and natural gas this coming winter - they don't have as much to spend on clothes, electronics, vacations, and other things, he points out.

Before people get too worried about the stock market's summer doldrums, however, some perspective is needed, experts say. "After the kind of run-up we had [in 2003], there's going to be a pause where the market digests its gains," Mr. Brayman says. "It's a normal process where people take money off the table from big winners and other people start coming in."

Years of nowhere

Stocks followed a similar pattern in the early 1990s, Applegate notes. In 1994, for example, the return for stocks was close to zero, even though the United States was in the third year of a business expansion. A similar pattern developed in the summer of 1991, he recalls, "where the market went sideways to nowhere for a few quarters."

"We're going through a very normal process of consolidating some of the gains from last year," Schwab's Sonders agrees. "In the first two years of typical bull markets, you have a very strong first year, and a little bit flatter second year."

Rather than worrying about the sideways market, she contends, investors should see this as an opportunity.

"It's not only an opportunity to buy, but it's an opportunity to rebalance," she says. "In this environment of relatively flat returns, a lot of stocks are up a ton and a lot of stocks are down a lot. If you do your homework, you can maybe sell some of those positions that have made money and look into names that are less expensive."

Even investors in mutual funds may be able to benefit from the market's lull, experts point out. A good mutual fund should be able to ride through a variety of market conditions. But investors approaching retirement, for example, might want to use this opportunity to sell one of their riskier funds - such as a sector fund that focuses on a single industry - in favor of a more broadly invested fund with less price volatility.

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