So far, wall of worry has been formidable

The stock market, according to an old saying, likes to climb a wall of worry. These days, that wall is proving difficult to scale.

In the first half of the year the Russell 1000 index – which measures the movement in large stocks – was almost flat, indicating the market was making little progress.

The degree to which that wall will prove formidable in the next few months depends on a few key variables, particularly the pace of interest rate increases and the oil price. If the market encounters severe resistance it might slide and give up trying to climb further until circumstances change; but, of course, if the worries lessen and it can handle the resistance, the market might climb the wall quite handily.

The first, and foremost, worry is the rise in short term interest rates and how long it will continue. The Federal Reserve is raising rates because it wants to head off higher inflation, but investors are concerned that it will keep raising the Fed Funds rate until it hurts.

The market consensus, based on the Fed Funds Futures Contract Yield, appears to be pricing in three quarter-point rate raises by the end of the year, but if the Fed raises rates more than that consensus, it might slow economic growth and possibly even induce a recession.

That is why, in June when Russell asked investment managers what their main concern was, one in four replied “interest rates,” putting that worry at the top of the list of concerns in our quarterly survey of investment sentiment.

Higher short-term rates mean consumers face higher payments on adjustable-rate mortgages and credit cards, leaving them with less discretionary cash, which, in turn, could dent both the housing market and corporate revenues.

In his recent upbeat testimony to Congress, Fed Chairman Alan Greenspan identified three “significant uncertainties:” inflation pressures from the labor market, high energy prices and the conundrum of low long-term interest rates.

Each time Greenspan has spoken recently, he has reiterated that the Fed intends to keep raising rates. The market, however, is waiting for Greenspan to signal an end to the tightening cycle. If he does, equities might rally, as such a move would indicate that the Fed is confident inflation is under control and the U.S. economy faces less danger from overheating.

A second worry is the price of oil. Although some believe the price might have peaked, others note that it takes 12 months for the price of oil to filter through to the economy, so we may not yet have seen the impact of $60-a-barrel oil.

High energy prices suppress corporate profitability and stifle equity returns. If the Fed underestimates the impact of the oil price and continues raising short-term rates beyond a reasonable level, both the economy and stock market will suffer.

Another concern is that earnings growth, although still likely to be 8 percent to 10 percent for the second quarter, is slowing.

At the same time, however, positive news is chipping away at the wall of worry.

For example, consumers still appear to be resilient to the effects of higher short term rates and the relatively high oil price. Housing remains strong. And companies appear to have considerable cash on their balance sheets that can be used for future growth.

In addition, large-cap growth stocks look attractive. Their valuations are relatively low, particularly compared with value stocks, which have enjoyed a good run during the past five years.

The keys to how the markets move in the next months, therefore, would appear to be the trend in interest rates, moves in the price of oil and the degree to which consumer spending holds up.

If those factors are favorable, the stock market might have an easier time scaling the wall of worry than it has so far this year.