Mellody Hobson: Is the Economy Still Strong?

June 7, 2006 — -- After a period of robust (and unsustainable) growth during the past three years, the economy appears to be slowing. The question: Is the economy still strong or are we entering a period of slowed growth?

Both the Consumer Confidence and the Expectations indexes were down in May, according to the Conference Board. Another indicator of a slowdown was the May jobs report. Nonfarm payrolls rose only 75,000 during the month, as opposed to a predicted 180,000 gain. Additionally, consumer spending, which represents two-thirds of all spending, has slowed in reaction to higher oil prices. Lastly, the housing market, which has helped to fuel economic growth over the past few years, is cooling, partially in reaction to rising mortgage rates.

The bottom line is that we are at a tipping point. Our economic environment is shifting right before our eyes.

Mellody Hobson takes a look at some of the key questions facing the economy in the coming weeks and months:

What is happening with the stock market? Are we in the midst of a correction?
This has certainly been a rough couple of weeks. Just looking at the stock market performance this week, Monday was the third worst one-day sell-off of 2006 for the Dow and the second worst day of the year for the S&P 500 and Nasdaq. Stocks had been lower earlier in the day on Monday due a declining dollar as well as rising oil prices related to threats by Iran, and they took a further drop after Federal Reserve Chairman Ben Bernanke's speech, when he commented on inflation fears and a slowing economy.

The Fed chairman's comments signal that the market might take a hit in the future. With no new economic reports on Tuesday, his comments had a lingering effect on the market, and stocks once again fell. Since coming within 80 points of its all-time high on May 10, the Dow has dropped more than 640 points -- roughly 5.5 percent. Most of that is a result of inflation concerns and interest rate speculation.

It's important to note that the markets are in the midst of the third-longest trading period in U.S. history without a correction -- which is defined as a decline of at least 10 percent in a major stock index. Historically, corrections have occurred every 222 days, on average, and we are now nearing 815 days.

Given the drop in the market over the past few weeks, we very well could be halfway through a correction, which is not necessarily a bad thing -- primarily because you can buy stocks at better values. Although there are understandably fears surrounding price drops, it is important to keep in mind that healthy markets undergo corrections, and the less overheated the market becomes, the less radical the correction will be.

There has been some talk about "stagflation.?" What does this mean?
"Stagflation" is scary word, but it is actually a pretty simple concept. Stagflation is the term used to describe a period of high prices coupled with a weakening economy. It is somewhat counter-intuitive because you would think that when the economy slows, prices would fall. The last time we saw stagflation in the United States was during the 1970s, and only time will tell if we are experiencing it again.

Do Fed Chairman Ben Bernanke's comments on Monday mean the Fed will raise rates again later this month?
After Bernanke's comments on Monday, all signs point to a rate hike. Bernanke was very clear in his remarks: The increases in measures of inflation are "unwelcome," and he will work to ensure the trend does not continue.

The fed funds rate -- the rate banks pay for overnight loans -- is currently at 5 percent. Expect a rate hike of a quarter point in June. Additionally, it would not be surprising to see more rate hikes later this year. Many assumed there would be a break, but with this new information, the market is grappling with the fact that further rate hikes lie ahead.

What does this mean for consumers?
First, higher interest rates are bad for stocks, meaning your portfolio may see some short-term losses. However, you should remain invested if you own great businesses and strong mutual funds -- just buckle your seat belt because you may be in for a bumpy ride.

Second, interest rates influence the sales environment -- they affect home purchases, car purchases and credit card rates. So it may cost you more to buy a home or car, and if you are the type to carry a balance on your credit card, you are going to be paying more interest on your debt.

Where should people be investing in now?
Investors want to avoid "hot" stocks and industries because even if their prices have dropped slightly in recent weeks, these investments are not compelling values anymore. Rather, you should be looking at the areas of the market that have suffered the most but ultimately offer the biggest potential for a rebound. To minimize risk, seek quality companies that are niche players in their industries. You also want to find companies with a long history of success over both up and down markets. The three sectors that have fared the worst this year:

• Technology: While technology may offer some good values, this industry makes me nervous because the rapid obsolescence of products makes it difficult to know where a company will be a year from now.
• Health care: With the aging of baby boomers, the health care sector is poised to do well over the coming years. For example, just look at the number of prescription drugs an elderly person takes. According to a study by Families USA, the average number of prescriptions per elderly person was 28.5 in 2000. By 2010, the average number of prescriptions per elderly person is projected to grow to 38.5, an increase of 10 prescriptions, or 35 percent per senior, since 2000.
• Consumer staples: I have always been a big fan of the consumer staples sector. Regardless of what is going on with the economy, people are always going to buy basic consumer products such as razors, batteries, cereal, etc.

Lastly, cash is looking pretty good. In recent weeks, returns on money market funds and Treasuries have crossed 5 percent -- their highest levels since 2001 -- which is not a bad return on investment given the lack of risk.

When Bernanke replaced Alan Greenspan, Wall Street applauded the appointment because it was believed Bernanke was clear spoken and a far cry from "Greens-peak." Was this a false prophecy? Is he more confusing than Greenspan?
Absolutely not. Bernanke has been brutally honest and very clear. On a good day, you would be lucky to uncerstand 5 percent of what Greenspan had to say. Bernanke's most recent statements are a gift. The truth hurts, and most people don't want to hear it.

Mellody Hobson, president of Ariel Capital Management in Chicago (www.arielmutualfunds.com) is "Good Morning America's" personal finance expert.