HE FIRST THREE MONTHS OF THE YEAR were dominated by international events. Investors took defensive positions in the months leading to war and then followed every development when the conflict actually erupted in March.

Truth be told, many investors actually just stayed on the sidelines. Traders saw some opportunities as the market gyrated according to the day's news. When all was said and done, stocks finished the first quarter at roughly the same level where they began.

But now the war is winding down and first quarter earnings are out. Instead of being glued to CNN for the latest international news, investors can once again turn to CNBC and the financial news. Has anything really changed while they were away?

Mixed Bag

On the other hand, consumers have continued spending. Throughout the past three years, the consumer has been the stalwart of the struggling economy. Although the Iraq war cut into consumer sentiment, it's still relatively strong and recovering. That's usually a good sign for an economy emerging from recession.

Bonds Still the Place to Be

Source: Ibbotson Associates Despite all the fretting before the latest conflict with Iraq, stocks and government bonds finished fairly flat. Long-term corporate bonds did the best while small cap stocks fared the worst. All in all, bonds were the better performing asset class.

Inflation has also been held at bay. This is fairly remarkable given the generational low interest rates. The Federal Reserve may have worried about inflation as they slashed rates, but now they seem comfortable at the bottom.

Perhaps the worst thing about this situation is that monetary policy can be of little additional help. With rates near rock bottom, the Fed has few tools left.

The Bush administration tried to implement fiscal policy, but the democrats who couldn't oppose the war, chose to oppose economic growth instead. In an effort to spur real economic reform and not just stop-gap spending, the President proposed a tax cut featuring the end of double taxation of corporate dividends. The democrats first cut the proposal in half and then moved to eliminate any tax cut, arguing it would be too costly at a time when the war led to deficit spending.

We've always believed the best way to fight deficits is to grow the economy. Like any business, it's necessary to spend money to make money, and the economic stimulus from freeing investors of double taxation of dividends would have this effect. No, it wouldn't be a silver bullet to cure the economy this month, this quarter, or even this year, but it would lay the groundwork for a stronger economy not only now but in the future.

Many investors paid little attention to fiscal policy wrangling while they were still fixated on Iraq. Now that their focus has returned home, it will be interesting to see if they come down on the side of fiscal stimulus or the democrats' new found fiscal responsibility. Either way, you probably shouldn't count on fiscal policy to rescue the moribund economy.

Market Call

Bonds have been in a holding pattern of their own, but rather than languishing near lows like equities, they've been holding near recent highs. Few believe rates can remain a present levels for any sustained period of time, but international tensions led investors to the perceived safety of bonds.

"Perceived" is the key word here since any warming in the economy will quickly reverse bonds' fortunes. At such low levels, just a 1% jump in rates over the next twelve months could leave most bond investors with a negative return for the year. That's something that hasn't happened since 1994 but we'd give it better than even odds at this point.

Low and Holding

Source: Baseline Treasury Note rates have fallen dramatically over the past two years, but now appear to be in a holding pattern as investors turned to them during the current international crises. As they play out however, yields may again begin to rise.

So investors may not particularly like what they see when they return to the domestic market. It's probably still too early to make any major commitment to stocks, but way too late to go into to bonds. What's a prudent investor to do?

Turning Points

Still, as long as investors are afraid of stocks, bonds offer the only viable alternative. Sure, you'll hear gold bugs and real estate mavens tout their favorite investment, but these come with liquidity and transaction costs that are far different from traditional stocks and bonds. For most investors, the only real way to play them is through gold funds and REITs.

For bonds, the question isn't if rates will rise and prices fall but when? The strength of the economic recovery will be the determining factor. As conditions improve and more industrial capacity is utilized, the Fed will be more inclined to return short-term rates to more sustainable levels. At that point their focus will once again shift from resisting recession to heading off inflation.

The Fed affects the short end of the yield curve while inflation expectations control the long end. Short-term bonds will be most susceptible since the Fed will move long before inflation becomes a problem. Given this, short-term Treasury investors might want to consider moving to short-term high-grade corporate bonds in order to increase yield while reducing exposure to the Fed. Corporates haven't rallied as much as Treasuries and may actually strengthen a bit should the economy find its footing.

Much of this, of course, depends on an improving economy. If you're a bond trader or just want to avoid getting caught by rising interest rates, you need to keep a close eye on economic signals. Some are more meaningful than others.

Consider, for example, the Producer Price Index (PPI). This is the measure of the costs paid by manufacturers for the raw materials used in their production. Oddly enough, a moderate increase in the PPI would actually be a good sign.

Here's why: Prices of raw materials are determined just like other prices; they're based on supply and demand. A steady or falling PPI (as occurred in 2002) signals weak or falling demand for raw materials and indicates manufacturers expect little demand for their finished products. But when demand for materials increases (as has been the case so far in 2003), their prices and PPI will pick up, presumably indicating greater economic and manufacturing activity.

Capital spending is another leading indicator for the economy, stocks, and bonds. According to Baseline, over the past 15 years, capital spending and the S&P 500 have a correlation coefficient of +.81.

Leading Indicator

Source: Baseline For the past 15 years, capital spending has been highly correlated with stock performance. The relation strengthens if it's used as a leading indicator. Lately capital spending has stopped declining just as stocks have, too. Any improvement in capital spending would be a positive sign for stocks.

That’s not as technical as it sounds. Correlation is a statistical measure of how two series (in the case, capital spending and the S&P 500) move in relation to one another. If they move identically then they are perfectly correlated and have a correlation coefficient of +1. If they move in exactly opposite directions -- one goes up and the other goes down an equal amount -- then they are perfectly negatively correlated and have a correlation coefficient of –1. If they move randomly relative to each other, they aren’t related at all and have a correlation coefficient of 0.

Most relations fall somewhere in the middle. The closer they fall to +1 or –1, the stronger the relation. Those that approach 0 are weakly related -- if related at all.

So capital spending is quite highly correlated with the S&P 500. The correlation grows even stronger (+.82 to +.84) if capital spending is used as a 3-6 month leading indicator. In other words, changes in the level of capital spending give a good indication of similar increases in the S&P 500 in the next 3-6 months.

As you’ll notice from the nearby chart, capital spending tailed off in 2000 just around the time the S&P 500 peaked. Since then, it’s been on a downturn, just like the S&P 500. In the final quarter of 2002, capital spending finally leveled off in the same period the S&P 500 has been range bound. Many economists have predicted an upturn in capital spending for 2003. While the increase will probably be modest (10.9 vs. 10.7 in 2002), it would at least be a move in the right direction.

If the correlation with the S&P 500 holds, equities may pick up steam in the latter part of 2003 or the first part of 2004. Any renewed interest in stocks would come at the expense of bonds, as funds would flow from the latter to the former. As investors become more comfortable with the economic recovery, bonds will lose some of their allure as a safe haven and stocks will again appear attractive.

Now that investors can once again focus on the domestic financial markets, economic signals can provide important road signs. Some are already suggesting some positive developments.

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