| |
 May 2011 The Unknown and the Obvious The First Quarter of 2011 was a Surprise, the Rest of the Year Won't Be.
Equities marked the second anniversary of the rally which started on March 9, 2007 with the bull still running strong. Despite that February dip, the Dow Industrials posted their best first quarter in twelve years and the S&P 500’s was the best in thirteen. Smaller stocks of the S&P Mid Cap 400 and the Russell 2000 ended March at their highs for the year, +9.0 and +7.6%, respectively. While this may pale relative to some of the heady quarters in the heart of the tech stock run-up, these are still outstanding three-month returns. They look even better when compared them to the paltry 3.4% yield on the benchmark Ten-Year Treasury Bond. That yield, by the way, is just 0.15% above its January 1 level.
Stocks continued their run in the month of April, with major indexes finishing at or near their highs for the year. But the most impressive aspect of this 2011 run-up was how well stocks fared against an extremely worrisome background. Unemployment and home sales showed virtually no improvement over the period. Turmoil hit the Middle East and the U.S. entered yet another undeclared war. Oil prices spiked over $110 a barrel and U.S. consumers suffered collateral damage at the filling station. Nevertheless, stocks marched upward. When stocks can ignore a development that usually sends them swooning, the bull must indeed be on the loose. When the market can blank out all of these negatives at once, the bull must be on a rampage. Investors couldn't help but wonder what would have happened had the economic background been even a little bit more favorable. This isn't just whistling past the graveyard. As we saw in the late 1990s, stocks can run up for a prolonged period of time with nothing driving them other than greed and momentum, but that's not the case today. In fact, with so many market pundits warning that equities are overvalued one might argue the opposite: It's the smart money leading the market, not the bandwagon neophytes. There’s still plenty of money on the sidelines to support additional gains.
Headwinds or Tailwinds? At the beginning of the first quarter earnings reporting season, analysts expected profits on the S&P 500 to have grown by 12% year over year. Despite a few disappointments, that estimate has held fairly steady. Even the hapless financial sector got a boost from the Fed's last round of stress tests. Now freed to pay and even increase dividend distributions, an entirely new -- and currently underpriced -- corner of the market is available for investment. Headwinds persist, yet stocks may eventually find the wind at their back. Hopefully the coming quarter will resolve at least some of the hotspots in the Middle East. If so, crude oil prices may be able to once again reflect supply and demand rather than fear and uncertainty. Top-line growth which is slowly returning to manufacturers’ balance sheets will continue to drive earnings and hopefully, share prices. If so, returning demand may help unemployment to finally show some real improvement. Even the sour housing market has stabilized (albeit at low levels) and it, too, will eventually rebound.
The I-Word Another certainty is that the Fed is not the sole determinant of interest rates. You'd think so from the financial press, but that's just not the case. In fact, Japan may have the greatest immediate impact while the Fed fiddles with its quantitative easing. Japan is one of the major purchasers of U.S. government debt, but that may change as Japanese investors divert more capital to rebuilding their country following the March tragedy. With the Treasury ramping up the sale of bonds to meet the ever swelling national deficit, any decline in demand will drive down prices and raise yields. If the Fed does finally end the quantitative easing program, short-term rates could quickly rise. All of this raises the specter of inflation.
However, "short-term" is the key concept here. The rates managed by the Fed (Federal Funds Rate and Discount Rate) anchor the short-term end of the Treasury yield curve. Long-term rates -- those out fifteen years or longer -- are primarily driven by investors' long-term inflation expectations. Should the Fed tighten monetary policy by increasing or at least allowing short-term rates to rise, long-term yields could actually fall if investors become more confident that the Fed won't let inflation get out of control. This is not an uncommon occurrence when the central bank moves from an accommodative policy to a tighter stance. Of course interest rates aren't the only factor impacting inflation, prices play a role, too. As previously noted, commodities are already on the rise. Throw in medical and educational expenses and there's a pretty solid base of rising prices. Equity investors fear inflation because it increases the cost of doing business whether through higher borrowing costs or increases in the price of materials. Fixed income investors fear it even more because rising yields drive down the value of their current holdings. Assets with intrinsic value such as gold and silver are some of the few investments that actually hold their value during times of inflation. That’s why gasoline is averaging over $3.90 a gallon nationwide. It’s why gold and silver are now in uncharted territory. Even agricultural commodities have quietly joined the run-up. Thanks to the Fed’s “quantitative easing” the supply of dollars is rising just as fast if not faster than prices. For those old enough to remember, it’s hard not recall memories of the “stagflation” era of cardigan sweaters and malaise. Fortunately, one other major inflationary force of the 1970s is completely missing: Labor costs. Average hourly earnings have been flat for the past four months. On an annualized basis, wage inflation has averaged less than 1% across the period. That's the lowest it’s been in twenty-five years -- back to the old stagflation days. This may be partially attributable to the stubbornly high unemployment rate, yet it's not particularly common under similar circumstances in the past. Typically employers will attempt to increase productivity of current employees before hiring others. It's much cheaper to push current capital (labor included) to function at full capacity than to hire, train, and pay benefits for new workers. As a result, hours and earnings usually go up for the current workforce weeks if not months before unemployment comes down. So far in this recovery, that hasn't yet happened.
A Midsummer's Reading
The two-year equity rally has been fueled by an extremely accommodative Federal Reserve. With quantitative easing scheduled to end in June, the resulting jump in short-term yields will make bonds more attractive relative to stocks. Not only that, any monetary tightening (or perceived tightening) by the Fed may actually lower longer-term yields as investors fret less about future inflation. If so, intermediate and long-term bonds could even enjoy added appreciation potential when their values rise as their yields fall. Can the bull maintain its balance once the easy money training wheels are removed and there’s upward pressure on bond yields? You’ll get a better idea about all this as the second quarter winds down. Whatever happens to stocks and bonds in the final weeks of June may dictate the course for the rest of the year. And of course, the coming months will offer plenty of opportunities for unexpected events to derail the market. Yet one has to believe if equities could flourish in the first four months of 2011, they should be up to the task for at least a few more. Again, the month of June will be the best barometer. If the bull can weather it as well as it did from January to April, the second half of the year – and maybe even 2012 – could be very kind to investors. Search this site! Just enter you key word or words:
Get current quotes or follow your own custom portfolio,
courtesy of E-Line Financials:
|
||||||||||||||||||||||
HE FIRST FOUR MONTHS of 2011 seemed like a bumpy ride, particularly when stocks stumbled over 6% in late-February. But once it was all over, looking back with perfect hindsight, the results were remarkably good.
