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 May 2009 Cautious Optimism
Well guess what? Stocks have again been rising for roughly the same number of trading days. This time, the near-term high was even greater, +29.1 on April 29. Is this finally the end of the bear market? It would be silly to believe that this rally would be any different from the prior one if the fundamentals within the economy have remained the same. Fortunately, there are two major differences from last year's rally, but one critical factor still remains unchanged.
The Long and Short of It Well-timed and equally well telegraphed open-market purchases of Government securities have effectively kept interest rates stable and low -- at least at the short end of the yield curve. Typically the Fed only acts on the short end of the curve, adjusting the Discount and Federal Funds rates. Even so, the entire yield curve tends to mirror the moves. Now, with short-term rates as low as they can practically go, the March 18th decision to initiate a $300 billion dollar buyback of government securities including 10-30 year maturities should help keep longer rates in even greater check. When the Fed makes open market purchases, it adds cash and removes existing securities. This increases the money supply and adds to market liquidity, just what's needed in frozen markets. Nevertheless, it still hasn't had the expected effect on the long end of the yield curve. Inflation is fixed income investors' worst enemy. It erodes the value of their fixed coupons and the longer their investments are tied up, the greater the effect. Generally when liquidity is high and interest rates are low, inflation follows. This may seem like a distant worry when month to month inflation rates are actually declining (as they have over the past few months), but the seeds of significant inflation have been and continue to be planted by the free-spending Congress and President. Because of this, investors are afraid to commit to long-term bonds, choosing instead to focus on shorter maturities. Despite their rock-bottom rates, shorter maturities are attractive because they will mature sooner in the face of rising inflation. As a result, the yield curve has steepened, with longer bonds hanging onto their higher yields as shorter maturities have fallen. Despite this uneven reaction, yields have remained relatively stable since the Fed began its "quantitative easing". (That's the polite term you hear economists use instead of calling it what it really is, printing money.) Truth be told, a steeper yield curve is just what the doctor ordered for banks because it enables them to pay low short-term rates on deposits while collecting loan interest at the higher long-term rates. The difference between the two is their interest margin, or profit, so this is an ideal pattern. Interest rates were fluctuating as 2008 came to a close. At that point they could have either collapsed under deflationary pressure or shot back up as a result of excess liquidity. No one knew which direction they would head. Now, much of that uncertainty has been eliminated and the credit markets are beginning to stabilize, too. A more predictable environment has enabled adventuresome investors to tiptoe back into bonds. Believe it or not, the high-yield market (polite term for junk bonds) has also started to show signs of life. Over the last few weeks of April, companies -- some with less than stellar credit ratings -- have been able to issue new debt into a fully subscribed market. As long as the demand persists, more and more companies will take advantages of today's low rates to tap the credit market. While it's still not business as usual, this is a remarkably positive and unexpected development, one that virtually no one would have anticipated even at the peak of last year's equity rally.
In the Trough? Even more importantly, banks such as JPMorgan, Goldman Sachs, and Wells Fargo surprised the market by posting quarterly gains. To be sure, this good fortune didn't extend to all banks, only the more conservative and well capitalized. In mid-April Thomson Reuters' analysts consensus called for a 49% decline in financial earnings, down from -40% at the beginning of the month. No one could reasonably expect the bleeding to stop all at once or for earnings to turn on a dime, yet the fact that even some financials -- the epicenter of the current downturn -- could begin to post actual gains in this quarter has got to be seen as a definite improvement from fourth quarter 2008 where there was no relief in sight. When you combine the improvements in the credit market with stabilizing earnings even in the troubled financials, evidence begins to mount suggesting the March-April equity rally marks the end of the 18-month bear market.
Hanging Tough What we've seen in the past six weeks is a nice stock rally, but it's hardly and "all clear" signal. As we saw from November - early January, stocks can run up yet run just as quickly back down when troubled market conditions persist. On the other hand, the fact that stocks can rally in the face of mixed economic and market data is a positive sign. Earlier this year, just about every development was perceived as negative and stocks gyrated on the news of the day. Improvements in the credit market and corporate earnings are true fundamental changes. There's still a lot of work to be done before we can declare the bear is dead, but at least the groundwork is now being laid. Earnings are still down and unemployment is still rising. Then again, these are generally considered lagging, not leading indicators. At least now it's possible to visualize how this recession will come to an end whereas just a month or two ago there was no end in sight. No one can reliably put a timeline on it, but with the first quarter's improvements and hopefully those to follow, the outline of the recovery will slowly come into sharper focus over the next quarter or two. Search this site! Just enter you key word or words:
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FTER HITTING A NEAR-TERM LOW on November 20, stocks finished 2008 with a powerful rally. Over the next 31 trading days, the S&P 500 rose by 24.4%, far surpassing the usual 20% gain generally thought to end a bear market. But the rally quickly succumbed in the early weeks of January as dismal fourth quarter earnings reports began to trickle out. By March 9, 2009, the S&P was 11% lower than it had been on the prior November 20. Obviously this wasn't the end of the bear market, just another false start.
