September 2003
Rate Wait
| "The sum of all human wisdom is contained in these two words: Wait and Hope. " |
| -- Alexander Dumas The Count of Monte Cristo |
OR A WHILE THERE, IT WAS the perfect environment for stocks: the economy was rebounding, inflation was tame, and both fiscal and monetary policy were accommodative. To top it all off, interest rates were low and falling. It's no wonder stocks staged a powerful second quarter rally.
But it didn't carry over into the third quarter. Ever since mid-June, stocks have been stuck in a trading range. What changed?
Much of the equity rally was predicated on investors' belief that the economy and corporate earnings would recover in the second half of the year. Indeed, evidence is surfacing to support that premise: Factory orders and productivity are rising, retail sales remain strong, and second quarter GDP outpaced optimistic estimates.
There's even positive news on the employment front. Although the economy isn't producing new jobs yet, weekly jobless claims have declined to the extent that the four-week moving average is once again below 400,000. Employment is a lagging indicator so if it's starting to level off, it too is confirming an economic rebound.
Yet the equity stall isn't just a case of "buy the rumor and sell the fact". There's more at work here, and it's tied to interest rates.
Overshooting in Both Directions
Often when the economy moves from recession to expansion, inflation starts to become a problem. That's not the case this time -- at least if you believe the Fed. According to their statement from the August 12th FOMC meeting, the threats of inflation and deflation are roughly equivalent.Through July, inflation -- both at the producer and consumer levels -- has increased at a remarkably tepid pace. We estimate that the CPI and PPI will finish 2003 up 2.3% and 2.7%, respectively. At these levels, neither is too threatening.
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 Data Source: Baseline Interest rates jumped up over 1% earlier this summer leading many to question the effects of "high" rates on the fledgling economic recovery. But how do you define "high"? While the 10-Year Treasury yield is considerably higher than it was just two months ago, it's still substantially lower than it has been at almost any time in the past 20 years. Aside from the past three years -- when rates were near their lowest -- the economy did pretty well. |
The Fed is evidently unconcerned. In fact, as a reassurance to bond investors, the FOMC promised that "policy accommodation can be maintained for a considerable period." In other words, they won't be raising rates anytime soon. Such a proactive Fed wouldn't make such a statement if they thought inflation was an imminent threat.
Normally that would be good for bond holders since inflation tends to erode the value of fixed income investments. But right now, bond investors are having trouble believing the Fed. That's why they sent yields to twelve month highs the day after the Fed issued their statement.
This isn't as screwy as it sounds. Many bond investors feel they've already been misled once by the Fed and are reluctant to be led astray a second time.
It all goes back to some of the statements from Fed governors prior to the June FOMC meeting. At that point with the economy still struggling, they sent a strong message that they would take decisive action to preclude even the slightest threat of deflation. This could include a 13th rate cut as well as "non-traditional" moves such as purchasing longer-date Treasuries in the open market.
Bond investors reacted accordingly, sending yields to 45-year lows. When the FOMC met in June and merely trimmed the Fed Funds rate by 1/4%, yields at the short end backed up. The 10-year yield took off later in July when Alan Greenspan implied in his Humphrey-Hawkins testimony that he saw little need for non-traditional monetary policy at this time.
Investors who had acted in anticipation of "decisive" Fed action were caught on the wrong side of the trade, so it's understandable that they'd be a 
little reluctant to believe the Fed this time. Despite the Fed's stated willingness to keep rates low, investors wonder how long they can really do so if the economy continues to strengthen.
Truth be told, bond investors overreacted on both the upside as well as the downside. A 3.1% yield on the 10-year Treasury was clearly unsustainable and overstated the degree of potential monetary action. The subsequent 1.5% spike was equally overdone. The correct level is probably somewhere between these extremes, but not at either.
Not to be left out, stock investors also overreacted. With rates spiking up, the bulls suddenly became timid, wondering how share prices could continue to advance with interest rates now so high.
While it's true that 4.6% is almost 50% higher than 3.1%, don't let the percentages fool you. Even at their highest recent levels, yields are essentially where they were twelve months ago when the consensus held they couldn't fall much further. Looking back, they are still at what would be historically labeled low levels.
The Waiting Range
One thing's for certain: Stocks spent the summer going nowhere. From early June through August the S&P 500 has been range bound between 960-1020. It seems that rising interest rates were the death knell for the spring equity rally.The easy explanation is that higher yields made bonds more attractive relative to stocks. This is often the case in a rising rate environment.
But don't lose sight of how far rates have risen -- they're only back to the levels of last year and are still well below the historical average. Are investors really that anxious to lock in a 4.5 - 5% yield? If the economy really is recovering, these rates won't look that attractive several years down the line.
No, relative -- and even absolute -- rate levels aren't the cause of stocks' summer malaise. It's the short-term trend that's to blame.
To see why this is the case, consider the markets of 1994. As in the spring of 2003, stocks began on an uptrend while bond yields rested at near-term lows. According to data from Ibbotson Associates, intermediate term Treasury rates rose most of the year and by November were 2.6% above their February levels. During that period, stocks stagnated, spending most of the year in negative territory.
Once yields peaked in November 1994, stocks resumed their upward trend. They finished the year up a mere 1.3% but the great bull market of the 1990s had begun. Yields slowly drifted down, but didn't return to their February 1994 level until August 1998.
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 Data Source: Ibbotson Associates The shaded area of the chart highlights the period of 1994 when intermediate term interest rates abruptly rose 2.6%. The S&P 500 traded sideways to slightly negative until rates stopped rising, at which point it was off to the races until 2000. Rates didn't have to fall to reignite stocks, they just had to stop rising. |
In 1994, as in 2003, stocks hesitated while rates climbed. A major difference between the two years is why they rose. Back in 1994, the Federal Reserve was actively engaged in a tightening policy. currently, they're sending the opposite signal, promising to hold the line for the immediate future. As suggested above, yields are now climbing because investors overshot the mark on the downside.
Yet we'd submit the determining factor isn't why rates are rising but rather it's investors' perception of the short-term trend.
After all, stocks resumed their rally in November 1994 although rates were 2.6% higher than they were nine months before. This couldn't be totally explained by the belief that the Fed would soon be more accommodative, especially since it took almost four years before rates returned to their early 1994 levels.
Instead, we'd suggest the equity catalyst came from the belief that at least in the short-term, yields would no longer be rising. They may not have been ready to plummet, but at least they had stopped rising.
It's often said that markets hate uncertainty. When interest rates are rising (or even falling for that matter) there is additional uncertainty and risk, especially for long-term investors. When rates stabilize -- even at higher levels -- investors can be more confident in their investment decisions. That's what happened in 1994 and there's no reason to believe it will be different in 2003.
Stocks are biding time, waiting for bonds to find a trading range of their own. We suspect the 10-Year Treasury spent most of August establishing it between 4.3 - 4.8%. Anything over 5% might spark fears of returning inflation while a fall below 4% would again signal a declining economy.
If bonds can stabilize here, stocks can finish the year with more than the traditional year-end rally. Unless bond investors continue to panic and overreact, this is the most likely scenario.
Worth a Trade
Actually the summer slowdown may have been just what the doctor ordered for the stock market. After the spring run up, the pause allowed earnings to catch up with prices.Few market observers had expected double-digit returns this year, but they got them in one quarter alone. Rising share prices are to be expected in an improving economy, but so far prices have improved far more than the economy.
This year's rally was led by the high beta stocks, most notably, Tech. Despite the bursting of the Tech bubble, investors still want to believe in Tech's leadership. At least this spring, wishing made it so.
The same holds true for smaller, riskier stocks. Indeed, some of the poorest domestic performers were stocks of large blue chip companies. These are the ones that are well capitalized, well known, and widely held.
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 Data Source: Baseline When interest rates started rising on the 10-Year Treasury, the S&P 500 stalled. Once the bond entered a range in early August, stocks resumed their climb, moving to 14 month highs in early September. |
They're also some of the biggest dividend payers. You'd think this year's dividend tax cut might have given them a boost, but you'd be wrong. Investors sought risk, not liquidity.
According to Baseline, for the first seven months of the year, the 217 stocks of the S&P 500 that offered yields above the index average 1.6% had a total return of 8.8%. That's not too shabby -- especially in light of the past three years' equity performance -- but it pales in comparison to the 19.3% return of those with below average dividends
At some point this gap will close. It may be sooner rather than later as Tech earnings will be hard pressed to match the expectations already reflected in share prices. In addition, total return stocks may gain appeal when investors' thoughts turn to year-end tax planning.
Whether you're a short-term trader or long-term investor, there's a trade here. Traders should consider cashing out some of their Tech gains before third quarter earnings warnings come out in late September and early October. Shares of real stocks of real companies with real earnings are still real -- well, somewhat -- cheap and would offer a good alternative for the proceeds.
Long-term investors also still have an opportunity to add to core total return holdings at fair prices. It's also not too late to upgrade portfolio quality by selling lower quality issues and replacing them with blue chips.
These trades will no longer be available when leadership moves from low quality cyclical issues into traditional growth shares. This is the traditional bull market rotation so investors would do well to take advantage of the current trading range while they can.
Sideways markets aren't necessarily bad, especially when they allow gains to be consolidated and earnings to catch up. Range bound trading would be welcomed in the fixed income market especially given the volatility of June and July.
It doesn't really matter that rates are higher now than they were at their lows in June. What does matter is that they stabilize before rising much further. If so, the economy, corporate earnings, and yes even stocks, can continue to strengthen.
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