The Economy & The Fed
The Fed medicine provided 10 days ago has completely cured the very ill patient as stocks rose furiously last week. Not only did the Fed eradicate the Ebola virus worries, but also allayed fears of European economic slowing and falling energy prices of two weeks ago. Although energy prices in the US have yet to get off the mat, the lower prices have morphed from signs of economic slowing here to a boon for consumers with added spending cash for the Christmas holiday. The glass that was half empty is now half full. The tenor of the US economic data has changed little over the past few months, pointing to modest economic growth with very low inflation. Last week was significant more for the earnings reports than the economic data. Multi-national companies like Coke, IBM and McDonald’s all struggled for various reasons with both revenue and earnings growth. “Dirty” stocks, like Caterpillar, General Motors and MMM were among those with surprising growth. This week still sees plenty of earnings reports, but the usual Fed meeting where it is expected they will end their QE policy (for now) and an initial guess for third quarter US economic growth will likely be the focus for investors. The markets remain very volatile, but when the result is higher stock prices, no one worries about volatility.
The expected bounce has come much faster and more furious than any would have guessed. The key is not that a rally occurred, but what happens when the fun wears off. That may happen over the next week or two and could help determine the overall direction of stock prices through the first quarter of next year. There are a few things to worry about with the rally. Volume, which rose dramatically during the decline, has fallen quickly during the rally to roughly average levels for the year. The high volume selling and modest volume buying indicated investors were much more interested in selling than buying during October. While not yet to “overbought” territory, the rally has put many indicators back into the higher than normal range that have characterized the markets for much of the year. That said, the markets may still make a run at all-time highs. Investor’s sentiment remains very bearish, meaning investors are much more worried about falling prices than rising. Usually in this environment, the markets do rise, forcing them to buy back into stocks. Interest rates remain very low, even after the Fed finishes later this week, giving investors only one place to get any type of return on their money: the stock market.
The bond market should have declined just as harshly as stocks rose, however bond yields remain very close to their yearly lows. It has been said the bond market is the adult and the stock market the petulant child. If so, the bond market remains worried about falling inflation rates around the world and the implications for lower energy prices. The bond model continues to point to lower interest rates ahead, with very little in the way of worries that could push bond yields significantly higher in the weeks/months ahead. If the Fed is to be taken at their word, then the QE policy may indeed end this week, but higher interest rates may not be showing up for quite some time. Wages growth, which remains roughly 2% annually, would need to get significantly above 3.5-4% before worries of inflation should be heeded.
The rally of the past week took everything higher and the SP500 is back to the levels of early October. However, within the market, there is a split between the industry groups. Energy has snapped back, but remains the weakest sector over the past three weeks, while utilities, healthcare and industrials have actually gained ground. We have gradually increased our exposure to healthcare over the course of the year and remain very favorable toward the group today. Utilities have been acting more as a safe haven or bond surrogate investment and have been a good gauge of investor fears. Even though stocks rose smartly last week, so did utilities. The rally also put the SP500 above its long-term average, after dipping below that level a week earlier, but much of the remaining asset classes remain well below their long-term averages, indicating a still very US-centric market.
The market did have large daily swings last week, but with those swings being higher, investor’s stopped worrying and embraced stocks again. The Fed meeting this week and the preliminary report on GDP in the US may move the markets this week. We continue to focus on large US stocks with a sprinkling of REITs and healthcare as well. Bond investors can still earn a decent return by buying/holding bonds with 7-10 years to maturity. Even though the QE policy will likely end at this week’s Fed meeting, interest rates are not likely to rise until late 2015 at the earliest.
The opinions expressed in the Investment Newsletter are those of the author and are based upon information that is believed to be accurate and reliable, but are opinions and do not constitute a guarantee of present or future financial market conditions.