Have Interest Rates Peaked?

Check out this weekly chart of the yield on the 10-year U.S. Treasury bond.
Sure looks like interest rates peaked around the middle of June. The data we've discussed in prior posts is backward looking and at best is confirmation of our views. Markets, on the other hand, tend to be forward looking. We believe this change in Treasury yields is an important indicator of a more favorable interest rate environment going forward - an important positive factor for the stock market.

Data Starting to Support Fed's Pause

In just the last few days we have seen more data suggesting that the Fed's pause in hiking short term interest rates was both justified and likely to be sustained for more than a couple of months. In particular, today's announcement from the government's Bureau of Economic Analysis of solid growth in consumer spending and incomes and slightly better news on inflation. Take a look at this chart we found at Joe Ellis' Ahead of the Curve web site comparing the PCE deflator (lagged three months) versus the fed funds rate. Importantly, it appears that the Fed has finally got the fed funds rate above inflation. We'd conclude that any stability in the inflation numbers should translate in to a less "hawkish" Fed.

All in all,this is good news for the stock market in our view. It appears that the economy is growing (perhaps at a slower rate) and inflation/interest rates stabilizing. Stable interest rates will take some of the pressure off valuations and perhaps drive increased demand for stocks.

By the way, there are a lot of intersting charts and analysis at the Ahead of the Curve web site maintained by Joseph H. Ellis, a partner of Goldman Sachs who was ranked for eighteen consecutive years by Institutional Investor magazine as Wall Street’s #1 retail-industry analyst. The website is based on his recently published book Ahead of the Curve. It's certainly worth a look.

Gas Prices Down, Stock Prices Up?

Wholesale gasoline prices have fallen sharply in the past couple of weeks. Indeed, according to the American Petroleum Institute, wholesale gasoline fell 7.6% during the week ended August 21, 2006 and now stands 14.5% below the record high price set on September, 5, 2005. We are already seeing the impact at the gas pumps. In our state, Massachusetts, regular has broken below $3.00 per gallon. We suspect we'll see further declines after Labor Day as summer driving demands lessen. This is clearly good news for drivers. It may also be good news for investors.

Why? Money not spent on gas will be spent elsewhere, giving a boost to retailers. Consumer confidence should improve as stability returns to the gasoline pump. And, most importantly in our view, stable or falling gas prices should help reduce inflationary pressures and perhaps let the Fed leave interest rates alone for a while. Reduced inflation, stable interest rates, and improved consumer sentiment should add up to a better environment for stocks.

Obviously, a serious disruption in oil supplies or refinery capacity would play havoc with our positive scenario. So, we'll be watching the pump and the Weather Channel for the next month or so. Let's hope for a mild hurricane season!

Supply vs. Demand

The law of supply and demand is one of the basic underpinnings of economics. It applies to practically all aspects of economic activity - including the stock market.

We recently reviewed this chart from Ned Davis Research which shows that the supply of stock has been shrinking at an accelerating rate for the past several quarters. Share buyback's and merger & acquisition activity are more than offsetting new equity issuance from IPO's and the like.

When you have stable demand for a good (milk, gasoline, or in this case, stocks) and supply is reduced, the price is adjusted upward until a new equilibrium between supply and demand is reached. So one could conclude that the reduced supply of stocks should have a positive impact on share prices (again assuming stable demand). And a reduced supply of stock with coupled with rising demand could put significant upward pressure on stock prices.

Of course, demand for stocks is not stable. It is affected by a myriad of variables in addition to the supply of shares, including economic activity and corporate profits to the search for Bin Laden. Indeed, demand for stocks has been ebbing of late given all the concerns we have discussed in previous posts, leaving stock prices stable at best. So, a shrinking supply of stock by itself is certainly not a guarantee of future gains.

What intrigues us is the notion that when demand for stocks does return, the reduced supply should provide additional help moving share prices higher.

Investment Lessons from Tiger Woods

Tiger Woods has won the last three tournaments he has entered, starting with the British Open and culminating with his dominating performance at the PGA last weekend.  Common to all three wins was Tiger's limited use of the driver.

Tiger can hit a driver as far as anyone on tour.  It is exciting to watch and when everything is in synch, Tiger gains a huge advantage over the field by hitting the ball well down the fairway.  But, the driver is for most golfers, including Tiger, the least accurate club in the bag. When not well struck, it can cause a lot of trouble.  An investor would likely describe the driver as high return (distance) with high risk (low likelihood of keeping the ball on the fairway). 

Starting with the British Open, Tiger Woods made the decision that given the golf courses he was facing (the environment), he wasn't prepared to accept the potential for an errant shot using his driver (risk).  So he left the driver in the bag, using more accurate clubs to safely advance the ball off the tee. Tiger was thus able to win all three tournaments by executing a lower risk, consistent strategy of keeping the ball on the fairway and avoiding a disastrous mistake with his driver.

We believe the market environment today, is much like the golf courses Tiger has faced recently - having the potential to earn an acceptable return but punishing investor mistakes. And,  that Tiger's approach of controlling risk and executing a consistent strategy can work well when investing in today's uncertain times.

So we're leaving some of our higher risk investment strategies "in the bag" for now and instead staying focused on quality companies at reasonable valuations, keeping portfolios well diversified to mitigate some of the risks we've discussed in prior posts and trying to avoid mistakes. 

Is The Stock Market Correction Over?

One has to be impressed by the market action last week.  Major averages such as the Dow Jones Industrial Average and the S&P 500, rose between 2.65% and 5.16% leaving all but the Nasdaq Composite in positive territory for the year-to-date. 

Investors were encouraged by last week's economic news which seemed to indicate a slowdown in economic growth and hopes for lessening inflationary pressures.  Energy prices moderated as well, as it appeared (at least for now) that the conflict in Lebanon would not spiral out of control.  And, perhaps most importantly, corporate earnings growth remains solid.

Last week's market action begs the question: Is the correction, begun last May, finally over? 

We believe there are reasons to be constructive and we expect further gains over the balance of the year.  Our positive stance is based on the following observations

• Solid fundamentals: Q2 reports generally met or exceeded expectations;
• Attractive valuations: With stocks off their spring highs and earnings continuing to grow, valuations have fallen to reasonable levels;
• Stable interest rates: Rising rates are almost never good for stocks.  The Fed pause and last week's news points to at least some rate stability in the near term, the potential for cuts in 2007 and providing a better environment for the stock market.

While more sanguine about the market's future, we are also mindful of risks that could derail a market advance.  Will the Fed's 17 rate hikes ultimately tilt our economy into recession resulting in falling profits and stock prices?  Will the conflict in the Middle East spread, disrupting oil supplies and raising global tensions?  Will inflationary pressures force a resumption of Fed rate hikes? Answers to these questions, unknown today, will come in time. 

Between now and then we're reminded that the greatest opportunities are often present themselves when uncertainty is high.

More signs of slowing. . .

Today, the Conference Board's index of leading indicators was reported down 0.1% versus the consensus expectation of a 0.1% gain.  This is one more sign that economic growth is slowing and it should be viewed positively by those looking for the Fed to continue to stand pat on interest rates.  Our concern?  Slowing growth will make it harder for companies to grow their earnings perhaps offsetting any positive impact from lower rates. 

For a long time now, we've enjoyed reading Michael J. Mauboussin's "Mauboussin on Strategy" reports from Legg Mason Capital Management.  For those with the inclination, we would heartily recommend you visit Legg Mason's web site to read his latest report.  And, Michael has recently published a book, MORE THAN YOU KNOW, Finding Financial Wisdom in Unconventional Places, an updated compilation of many of his prior reports that is also worth a read.

Inflation Data OK . . . For Now

The Consumer Price Index data just released this morning offers some additional good news on the inflation/interest rate front.  Core CPI (excluding food and energy) rose 0.2% a bit less than was forecast while the overall CPI rose 0.4%, in line with expectations.  Other data out today on housing and industrial production painted a picture of slowing growth.  Indeed, July housing starts fell a bit more than expected while building permits declined sharply.  Industrial production rose 0.4% in July, a bit less than expected, indicating continued growth in the coming months but at perhaps at a slower rate.

Our take?  These reports certainly bolster the favorable inflation news from yesterday and raise the likelihood that inflation and interest rates have plateaued. While this is good news for investors, we're not out of the woods yet.  Along with the producer and consumer price indexes, we'll be watching the employment cost index and productivity numbers to give us a better feel on core inflation trend.  And we'll be watching the slowing economy's impact on corporate earnings in the coming months.   Falling inflation and rates are certainly positive for stock valuations.  But if earnings start to fall, it will be tough for stocks to make headway.   Stay tuned. . .

A pause that refreshes?

This is the inaugural post on our new blog, "Perspectives on Investing". Here we will comment on the markets, investment topics, news events, respond to your questions and more.

Last week, after seventeen straight quarter-point hikes, the Fed finally passed on raising short term interest rates at their regular meeting. Yet, the market was underwhelmed by the news. Why? The language in the Fed's press release left the door open to further hikes, perhaps as soon as the next meeting. It will depend on evidence that inflationary forces are indeed receding as Fed Chairman, Ben Bernanke expects.

From our perspective, that evidence is decidedly mixed so far. Recent employment data for example, shows job growth slowing but disturbingly, employment costs rising significantly faster than productivity. Employment costs are a key driver of core inflation, so the current situation is clearly of concern to us.

Today, we got favorable news on producer prices, with the core rate actually falling 0.1% last month. This good news has sent bond and stock markets upward as investors bet that the inflation news will continue to get better, that Ben Bernanke is right after all, and that the next direction for rates is down. Of course, there will be more news tomorrow and it's anyone's guess whether it will be good or bad, indicative of accelerating or decelerating inflation or an indicator of the Fed's next move.

Bottom line, we suspect that the market will continue to be volatile for the time being. Whether it's the violence in the Middle East, high oil prices, evidence of a slowing economy, concerns over corporate profits or uncertainty about the next Fed move, investors will find a reason to stay on the sidelines.

In our view, the correction that began last May will finally come to an end when some of these concerns are alleviated. We think a sustained stock market advance can occur once there is enough evidence that inflation is under control, that rates have at least stabilized and perhaps poised head lower. The risk to this scenario? Has Fed has already raised rates too much, the economy slows too much and corporate earnings slide? We'll just have to wait and see if this is the pause that refreshes.