In the February Monthly Market Monitor, the inherent contradiction of not adding Google to the S&P 500 was highlighted as well as the likelihood that it was to be added soon.  With only two months going by, the S&P 500 index managers have decided to add it officially to the index on Friday, March 31st.  It is important to note, that even though Google’s stock price has fallen by approximately 18% to $385 before being added to the S&P 500, its original IPO price was $89.  This suggests that the S&P 500 managers may have still overpaid for its inclusion, perhaps giving reason for active managers to now eliminate Google from their portfolios.  Historically, when companies are added to the S&P 500, they usually experience an immediate price appreciation, only to be disappointed by its performance in the coming quarters.  That was the case with names such as Amazon, Yahoo, and even IBM, when they were added to the S&P 500.  This was also the case when the Dow Jones index managers added Cisco, Intel, and Microsoft to the Dow Jones in November of 1999. 

Active managers will evaluate companies for their fundamentals, such as current earnings, earnings growth, and market share.  Passive index managers are often evaluating companies simply on their market capitalization.  Because fundamentals are frequently ignored when selecting members to be included/excluded, long-term prospects are seldom considered.  Instead the focus continues to be on near-term price impact of such decisions.  In the example of Google, David Blitzer, the S&P Index Committee Chairperson, stated that “the company would have added Google sooner, but shares were rising too quickly” (Source: Ignites 3/24/05).  Comments such as these reinforce the notion that the S&P managers are prone to market timing.  Unfortunately, given their track record with names such as IBM, Amazon, and Yahoo, they are more known for adding companies to the index at near-term highs, rather than lows.  In the case of Yahoo, it was added in December of 1999 with a market capitalization at the time of $60B.  Today, Yahoo has yet to revisit its 1999 price level of $50/share and now has a market capitalization of only $46B (a 23% decrease in share price since its addition in 1999).  Given that Google is still hitting new highs, very similar to Yahoo during 1999, it seems that the S&P 500 may be once again setting up its investors for further disappointment.

Now 15 Fed hikes since June of 2004

Even with a new chairman, Ben Bernanke, the Fed has continued to increase interest rates at their "steady and measured" pace.  In the most recent comments made by the Fed, the U.S. economy continues to be on strong footing and the risk of higher inflation is primary.  At the same time, Bernanke pointed out his view that those interpreting the flat yield curve as a portender to recession are probably off-base.  Instead, low long-term rates continue to stay low due to the low supply and high demand for higher yielding securities.  As interest rates continue to rise, it poses risk to both stock and bond investors.  Stock investors become more concerned because bonds become increasingly more competitive, with long-term investment grade corporate bonds now yielding north of 7% in some cases.  Bond investors always stand to lose as interest rates rise because interest rates and bonds prices have an inverse relationship.  In either case, the stakes are steadily increasing for both bond and stock investors as further interest rate hikes occur.  Currently, the bond futures perceives a 70% chance that the Fed will raise again in May, but many expect short-term rates to then settle at 5% (Source:  FedFundsRate.com 3/28/06).  Even though many Fed watchers were expecting that a more neutral stance on interest rates was going to be adopted during this last meeting in March, the Fed continues to keep them guessing.  This is the key advantage that both Bernanke and the Fed still possess.  Once a more "neutral stance" on interest rates is announced by the Fed, its influence over bond markets will be significantly reduced.  Until then, Bernanke will continue to keep the cards extremely close to his vest until an official change in the interest rate direction is warranted.  All of this suggests that the month of May should bring large swings to both U.S. stock and bond markets.  

Prepared by:  Robert Garland, MBA  

                        Vice President, Research Department

                        ING Advisors Network

       1   Dow Jones News 4/3/06

The views are those of Robert Garland, MBA, Vice President, Research Department/ING Advisors Network, and should not be construed as investment advice. All information is believed to be from reliable sources; however, we make no representation as to its completeness or accuracy.

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