US markets at risk

Morgan Stanley's Richard Berner and David Greenlaw think that sustained interest rate rises in 2005 will have a greater impact on asset prices than on the economy.

The hawkish tilt to the inflation debate in December's FOMC minutes has raised concerns among market participants that Fed officials will abandon their measured tightening pace and put either risky assets or the economy or both in jeopardy. The time-honored fear, of course, is that when the Fed steps on the brake, someone always goes through the windshield; investors just don't know who that someone will be this time around...

... [W]hile there's an endgame in every tightening cycle, it's important to distinguish between market and economic risks. In our view, there's much more risk in markets than in the economy. That's both because there's a lot of good news in the price of risky assets, and because the Fed will welcome somewhat less favorable financial conditions to keep inflation down but will also aim at healthy economic growth.

This view is quite consistent with the view I expressed in my commentary yesterday titled "Poor start to 2005 for US equities", in which I quoted Mark Hulbert of CBS MarketWatch as saying: "The S&P 500's current P/E ratio is either 46 percent above historical norms or 50 percent above. Your conclusion in either case should be the same: Stocks aren't cheap."

Which leaves US stocks vulnerable to the risk of a weaker-than-expected economy as the Federal Reserve keeps its tightening bias.