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 March 2006 News, Noise, and Knowledge
Investors can certainly be forgiven for feeling conflicted -- especially since the markets seem to be as well. Unless you're an active trader, it's hard to make money in such volatile and trendless conditions. Yet markets are cyclical so at some point a new trend will eventually be established. In fact, this is precisely why the economy appears to be sending mixed signals: A turning point is approaching. Savvy investors realize this and are positioning their portfolios, not based on the daily headlines but on the coming trends.
Market and economic conditions don't change overnight. Indeed, cycles have historically covered more than three years, so contrary to what the talking heads breathlessly say based on the news of today, things really haven't gotten dramatically worse (or better) since yesterday. It's all a matter of perspective. Daily news and market movements can be quite striking, but to truly understand the bigger picture, you need to step back and take a longer-term view. In this case, "longer-term" means more than just a day, a week, or even a few months. On the other hand, you don't have to be some sort of market anthropologist, either. To get a good handle on today's conditions and where they're heading, you don't have to look back any further than two years.
Real Trends But by June 2004, GDP growth was beginning to accelerate and employment was starting show signs of life. At that point the Fed began to tighten the money supply by slow, "measured", ¼-point increases with the goal of returning rates to a "neutral" level.
The benchmark 10-Year Treasury Note followed a similar path. As the Fed lowered short-term rates, its yield hit a low of 3.11% in June 2003. By the time the Fed began to push up rates in June 2004, the 10-year yield had climbed to 4.80% Contrary to what many mistakenly believe, the Fed wasn't raising rates to slow the economy but rather to head off inflation before it got a chance to actually get started. Inflation, as measured by the core Consumer Price Index (CPI), had been on the decline from late 2001 into early 2004 when it was growing at just slightly over 1% annually. However, by June of that year, it had accelerated to 1.8%, so the Fed believed it was time to switch from an accommodative policy. A great deal of the renewed inflationary pressures can be traced to rising energy costs. Crude oil, whose price had actually declined from 2001 into 2004, saw prices move up as a result of the Iraq confrontation. Although the rate of increases have slowed, energy prices continue to rise today. Higher interest rates and increased inflation rarely lead to gains in the stock market. Higher interest rates increase the cost of borrowing while higher inflation adds to the cost of raw materials. Both tend to reduce margins and corporate profits. Corporate earnings hit their low point in the recession of 2001 but rebounded strongly in 2002 and 2003. They peaked in early 2004, just three months before the Fed started to drain liquidity from the market. As is often the case, stock prices lagged behind earnings increases, not bottoming until early 2003. After that, stocks rose sharply into 2004.
Real Changes Each successive increase has fueled speculation that the Fed was nearing a stopping point. The first clear indications that the Fed agreed came from the post-meeting statement and minutes of the December 2005 FOMC meeting. Stocks reacted favorably, starting 2006 on a strong up note. Bonds were surprisingly subdued with yields on the 10-Year Treasury moving up ever so slightly to the 4.5 - 4.6% range.
The January FOMC meeting brought the expected ¼-point rate increase as well as some welcome words from the minutes. Although the attendees acknowledged that inflation was "somewhat higher than desirable", they went on to agree that "policy seemed close to where it needed to be given the current outlook." That was arguably the clearest sign that the tightening cycle was finally on its last legs. Ironically, just as the Fed was calling it quits, inflation seemed to be more of a threat than it had been in a long time. Prices at the consumer level jumped 0.7% in January 2006, a great deal being attributed to rising energy prices stemming from the tension with Iran. On a 12-month basis, core CPI which excludes volatile food and energy was up 2.1%, noticeably higher than the 1.8% increase in 2004 when the Fed initiated their rate hikes. Of course a great deal of this is again attributable to the jump in energy prices. Tensions in the Middle East and hurricane-related disruptions in this country have pushed prices higher regardless of U.S. monetary policy. After peaking around $70 late last year, crude oil prices seem to have stabilized in the $58 - $63 a barrel range. While no longer rising, this level is considerably higher than where it stood in 2004. Indeed, the energy component of CPI is almost 25% above its 2004 level. As Chicago Federal Reserve Bank President Michael Moskow recently told The Wall Street Journal, "We know that increases in energy are going to pass through to core [inflation]." Although Mr. Moskow is not a voting member of the FOMC, its members must realize this, too. Higher interest rates and inflation are already being felt at the corporate level. As you'd expect under such conditions, corporate profits, while still growing, are doing so at a declining rate. Looking back, earnings on the S&P 500 appear to have peaked in early 2004 -- just before the Fed started pushing rates higher. Since then, growth has decelerated and analysts expect this trend to continue at least through 2006. All of this has taken its toll on the overall economy. Growth in the Gross Domestic Product is typically taken as a proxy for the health of the economy. It appears to have hit a peak when it spiked to 7% quarter-over-quarter growth back in late 2003. Since then it held steady in the 3.75 - 4.00% range until the final quarter of 2005 when growth was barely over 1%.
Analysts attribute the lackluster fourth quarter number to the effects of the Gulf storms as well as slowing auto sales following the summer's major discounts. Many expect this year's first quarter to show a rebound, but not back into the range of 2004 - 2005. So far stocks have held up fairly well. The Dow Industrials crossed back over the 11,000 barrier in February and both the S&P Small Cap 600 and Russell 2000 are within just a few points of fresh all-time highs. Even so, it's important to recall that that delay observed back in 2003 - 2004 between earnings acceleration and share price growth holds this time, too. In other words, earnings are likely to cool for a few quarters before being reflected in share prices.
Real Meaning The one thing that stands out is that all these indicators show an economy in transition, moving from early-cycle high growth to later cycle moderation. It's no wonder short-term signals are conflicted, this always happens when a cycle moves from one phase to another. Each part of the economy moves at its own pace and not all turn at the same time. Armed with this knowledge, investors can make informed decisions rather than knee-jerk reactions to daily events. It's the longer-term trends that are investable while short-term gyrations are only tradable. The story seems fairly simple for bond investors: Stay short. Ever since late December 2005, short-term rates have eclipsed those of longer maturities. This so-called "inverted yield curve" usually occurs when investors believe monetary policy is too tight (elevating short-term yields) and inflation is no threat (allowing longer-term yields to fall). It's also often a harbinger of a recession.
Although it's always scary to say, "It's different this time," it may well be. While short-term rates are higher than they've been in five years, they're still relatively low by historical standards. Previously when inverted yield curves called recessions, they were substantially higher than today. It's hard to believe that short-term rates at 4½% or even 5% will choke off economic growth. Low long-term yields are often the symptom of lagging economic growth. That's not the case today, even if GDP does fall a bit. A more likely explanation of today's low long-term yields is the fact that inflation is still relatively low and the belief that the Fed is on top of it. These are both positive factors and not signs of an impending recession. Nevertheless, bond investors should focus on the short end of the yield curve, not for fear of inflation or recession, but because that's where capital gains are possible. Short-term yields have remained high in anticipation of further rate increases, but once the Fed makes it clear that the tightening cycle is over, they should stabilize or even fall. When this occurs, prices which move inversely with yields, should rise. On the other hand, longer maturities should see their yields rise. Without the Fed actively holding it at bay, investors will be less sanguine and require higher yields to compensate them for their greater risk of inflation. As a result, the yield curve will return to it's normal, upward-sloping pattern. That's not unusual in the later stages of an economic expansion. The course isn't as clear for equity investors. Slowing corporate profit growth and GDP would seem to suggest taking cover in defensive issues. Consumer Staples or Healthcare stocks would appear to fill the bill as everyone needs toothpaste and medicine regardless of the economic cycle. Value stocks would also seem to offer protection since their already depressed prices have less distance to fall. Oddly enough, however, neither of these have come to pass.
Value stocks fail to provide their traditional safeguards given that they've had quite a run in the past six years. When investors fled overpriced growth stocks at the turn of the century, value stocks were the equities of choice. They haven't looked back since so now there's arguably more value in neglected growth stocks. It's the downtrodden leaders of the late 1990s that have less to fall than the usual value safe havens. That could also explain why traditionally defensive sectors have also failed to perform. For two years now pundits have been expecting them to command more interest, but so far, that's not happened. They've also been calling for large cap stocks to assume leadership over their smaller counterparts. Small cap stocks have led the way for seven years now. They usually outperform in the early stages of an economic upturn as increased revenues have a greater impact on their bottom lines. As the cycle ages, large caps typically begin to dominate, but so far it's not happening this time. Stocks got out of the gate quickly this year. After the first two months, the Russell 2000 was up about 10%. At that rate, it still doesn't look like small stocks are relinquishing their lead. While large caps as measured by the Dow Industrials and the S&P 500 climbed only about 3%, that's nothing to sneeze at, either, given that the Dow was actually down fractionally for all of 2005. Unlike the fixed income market, there's no hot trend or sector. Perhaps that's again the function of the economy nearing an inflection point. The transition from early to late cycle leaders is just beginning and is far from complete. As a result, diversification is the safest course. High quality stocks from across the spectrum of size and styles offer the best opportunity. Information is powerful tool as long as it's used wisely. News and data flow much faster now than even just ten years ago. In a sense, "the good old days" may have really been the good old days as investors were forced to focus on the big picture rather than the day's fleeting headlines. There's really no bad information, just bad uses of information. Real investable data is out there, you just have to look beyond today's TV news. Search this site! Just enter you key word or words:
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NE DAY ENERGY PRICES SOAR, Iran takes a hard-line towards nuclear development, and several bellwethers reduce 2006 earnings forecasts. Stocks fall and bonds languish. The next day the government reports U.S. oil inventories are at their highest level since June 2005, core Consumer Prices are reported to be increasing at a mild 2.1% pace for the past 12 months, and the Fed strongly suggests the tightening cycle has just about run its course. Stocks and bonds both rise. What's going on here? Or is anything going on here?
