End of an Era and Buy the Dip
The S&P; 500 finally surpassed its all time High, the record of 1527.45 set on 03/24/00. It is the last one to cross that line, except of course the NASDAQ and all its sup-components. NASDAQ means technology and technology has been out since 2003. “In the ground” stocks are today’s leaders, technology stocks are the laggards. How times change. The dips were fleeting throughout the week while the S&P; 500 had its eye on the finish line. On Wednesday, early weakness linked to a China sell off was wiped out by aggressive afternoon buying after the release of the minutes of the Federal Reserve's May 9 policy meeting. Another successful week for the bulls was capped by Friday's gains in the wake of stronger-than-expected reports on non-farm payrolls and ISM Index as well as a dip in the year-over-year rate in the core personal consumption expenditures index. Thursday’s weaker-than-expected first-quarter revision to GDP could have disturbed some bulls, but did not. Growth estimates were cut in half from 1.2% to only 0.6%, which was the slowest since 2002. But the report already contained signs of underlying economic vibrancy. Cutting significantly into economic growth in recent quarters have been drags from cuts in business inventories and residential construction. The combined drag cut about 1.5 percentage points on average from GDP in each of the past two quarters. The drag now seems likely to shrink or disappear by the second half of the year. Inventory investment appears to be rebounding, as evidenced by numerous data on the factory sector, and residential construction is falling at a slower pace, as shown by recent housing starts, which seem to be running above the first-quarter average early in the current quarter. Declining inventories, a lesser drag from housing and an upward revision to consumer spending spurred many economists to raise the growth forecasts for the remainder of the year. Not surprisingly, investors continued to buy the dips.
As the first quarter GDP growth rate almost stalled, the ISM Index, which was also released last week continued to rise in April. The annualized growth rate also rose and entered positive territory for the first time in twelve months. Helping matters also was the Conference Board’s report that its May survey of consumer sentiment rose more than expected to a reading of 108, and revised April higher to 106.3. Analysts had expected a reading of 105. Fewer respondents rated jobs as hard to get, while the same number of respondents said jobs were plentiful. Consumers' assessment of the present economic situation and business conditions rose, as did expectations for the future. But the "dark cloud" in the consumer confidence report was rising inflation expectations to the highest reading since May 2006, writes Joe Brusuelas, chief U.S. economist at IDEA global.
While enthusiasm was building by Friday that the economy is going to reaccelerate in the second half of 2007, fixed income instruments were selling off and bond investors grew more nervous. U.S. 10-year Treasury note yields closed at a new high for the year of 4.96%. The weak performance of the bond markets around the world is reflecting the following factors:
- accelerating domestic and global economic growth (prospects for an economic rebound are significantly reducing the odds of a near-term rate cut)
- competition for capital (investors want to be compensated for the opportunity costs of holding bonds with stagnant returns instead of stocks with rising returns)
- central banks are diversifying (several central banks have publicly announced that they want to diversify away from fixed income instruments)
- inflation remains sticky (rising raw materials prices have caused a rise in consumer inflation expectations)
Treasury yields are moving along with global bond yields, which have risen in recent weeks on expectations for foreign central bank-tightening amid strong growth and inflation worries. But some of the move also may be a fundamental trade away from the economic gloom and doom that has benefited the fixed income markets in the past. The housing story is wearing thin as nothing has collapsed and the bond market is beginning to notice that. All these themes are reflected in the two charts above. Accelerating global and domestic growth is causing (and is caused by) rising money stocks, not only in the US but worldwide. You can see in the picture to the left that MZM has risen at an annualized rate of 7.5%. This amounts to a dramatic expansion of money, which in the end can only become inflationary. In the short run of course, it will push all kinds of assets (including stock prices) skyward. More money chases goods and returns around the globe, causing asset values and inflation expectations to rise. Central Banks respond by rising short term interest rates. Fixed income markets now respond by raising yields on long term instruments. The picture above to the right shows the current yield of 10-year T-Notes. I have drawn a trend line which shows that our yield background is about to change. Ever since 1981, we were living in a world of falling inflation and falling yields. The 10-year note declined from 15% in 1981 to a low of 3.3% in June of 2003. Inflation (reported or expected) declined throughout those 25 years. Not coincidentally, the stock market took off in 1982, when the S&P; 500 traded at around 110 and the Dow Jones Industrials around 1000. During the next 25 years bonds rallied, yields declined and both indices grew by 1,200%. This era is now coming to an end. In my opinion it is only a matter of time, before the 10-year note yield brakes through its prior peak of 5.25, reached last summer. If and when this happens, the 25 year old trend line will be broken and an era of rising inflation will begin. I am wondering if stocks will react to this development with a time lag or instantaneously. It seems that initially, stock investors do not mind a little inflation. It is good for revenues and profits. I guess it is the pervasiveness of inflation that eventually will make investors nervous.