A Little Respite

Today's gain of almost 100 points in the Dow Jones Industrial Average provides a least a short respite for investors after two terrible days in the stock market last week. The decline occurred despite the strong economic news released on Friday coupling strong GDP growth with fairly stable inflation and falling interest rates. The 10-year Treasury yield fell below 5% which we believe is an important bell weather for the market. The bottom line? We'd hang in there with equity positions as this market looks inexpensive to us on an earnings basis - particularly when compared to the 10-year Treasury as we think this should set the stage for further gains to the upside.

Back to Blogging on the Markets

It has been some time since my last post - the result of a busy work schedule and a bit of indifference thanks to the rising stock market.

I think most of us spend too much time on the minutiae - the daily economic reports, earnings results, interest rate spreads, etc. - and too little time on the big picture. Putting events into their proper context is an important component to successful investing.

It is interesting to note, therefore, that despite $3 gas, rising mortgage delinquencies, terror attacks, slowing economic growth, the market has made a significant advance with the Dow Jones Industrial Average crossing 14,000 for the first time in history!

Now, of course, we have started to experience some choppiness in the past several days including a couple of triple digit declines. And all of sudden, market participants have come to the conclusion that the sub-prime market woes will spread to the rest of the economy. Bill Gross, the famous bond manager from PIMCO, was on CNBC yesterday talking about a five to ten percent correction thanks to a widening spread between high quality and "junk" bonds. We'll he's right - spreads have widened but no more than back in 2005. Lending is not going to come to a halt, and the economy will continue to move ahead.

So put let's put the past few days in context. The market has done fine so far this year - indeed more than fine and a little correction is probably a good thing. The economy is growing, earnings are rising and interest rates have stabilized (at least for good credits!). So relax, don't listen to all the noise, and perhaps look for some bargains.

Four home runs in a row . . .

Last night, the Boston Red Sox, hit four consecutive home runs. At the time the Sox were trailing the hated New York Yankees by three runs. The four home run outburst powered the Sox past the Yanks and to ultimate victory.

Using last night's performance as an analogy for the stock market may be a bit of a reach but I'll try! And, since it's been a while since my last post, I'll be able to cover a lot of ground with it. Here goes:

Home run #1: The Economy. Without a doubt, the economy's growth rate has slowed from last year's levels. However, the final revision of the 2006 was upward to 2.6% from 2.0% so we ended the year with a bit of momentum. We'll find out how much in just a few days as the Q1:2007 GDP preliminary report is out on the 27th. We're betting that it will be a "decent" report (say 2% give or take) albeit slowing somewhat given the rocky housing numbers and some unexpectedly poor weather - particularly in March. Remember that employment has remained strong and the unemployment rate is still low. So people are working and spending money and growing the economy.

Home run #2: Inflation/Interest Rates. Despite spikes in some commodity costs (have you bought any gas recently!) core inflation rates remain relatively subdued. While they may be a "smidge" above the Fed's comfort level, they are not spiraling out of control. We think that given somewhat slower GDP growth, continuing concerns over the subprime mortage market (and its impact on housing overall), the Fed can and will stand pat for some time to come. Stable interest rates are good for the economy and the stock market.

Home run #3: Corporate Earnings: Earnings reports are starting to flood in and, so far, companies are meeting forecasts at a rate surpassing most investors expectations. In fact, it appeared to us that last month, investors were bracing for some major disappointments. And while there have been some high profile misses, such as Yahoo! and AMD, strong reports from the likes of Google, Caterpillar, and even Intel have driven the market to new highs.

Home run #4: Buyouts galore: It seems that we start every day with at least one, multi-billion dollar buyout. While many of the buyers are private equity firms and hedge funds, we're also seeing some significant corporate buyout activity as well - witness today's by of Medimmune by AstraZeneca. The result of all this activity is a meaningful reduction in the amount of publicly traded stock. The simple law of supply and demand continues to provide uplift to our stock markets.

Bottom line? A month ago it looked like game over for the stock market. However, thanks to the four "home runs" listed above, we're once again making new highs in the Dow Jones Industrials. Time will tell if the bull market will keep its lead over the bears - but I wouldn't leave the park just yet.

A Wake Up Call?

Yesterday's dramatic decline in stock markets globally is an important reminder of the risk of complacency. Since late Summer 2006, the market has risen steadily with only very minor reversals. We were once again reminded don't go up forever without at least a "technical" adjustment from time to time. And these adjustments can be swift and painful. However, investors with well diversified portfolios that kept their heads yesterday are still in great shape - no need to panic.

The big decline was perhaps sparked by the Chinese sell-off. However we think there may be more to it. The economy has slowed - GDP was revised downward to just up 2.2 and the Chicago PMI was below 50 again (above 50 is good, below not so good), the mortgage markets are jumpy, new housing starts are still falling fairly rapidly, the Democrats in control of Congress are looking to increase their share of your wallet and oil has bounced of its recent lows. All this uncertainty and and a stock market that has risen sharply off its lows seems ripe for a correction. It may have started yesterday. We don't think it will be too bad or too long and it should be a good environment for bargain hunters. So make a list of the stock you wish you had bought last summer and look for opportunities to build a position.

Focus on Expectations

A day after our post on using the market as a forecaster, the Wall Street Journal has an interesting article on a change in the way the Fed looks at employment and inflation. The Fed is becoming less concerned that in the short run high levels of employment or unemployment have a meaningful impact on inflation. Now, this doesn't mean changes in the level of employment will be totally ignored by the Fed, but it does seem less likely that the Fed will alter rates on employment changes. This is good news for interest rates in the current high employment environment.

The Fed has heightened its focus on inflationary expectations and changes therein. Review our prior post on the spread between 10yr TIPS and 10yr Treasuries. It is market based measure of inflation expectations. And today it shows expectations at a low ebb. Our bet, the Fed stands pat.

Markets as forecasters

We often talk about inflation in our posts. Why? The level and direction of inflation has a very important impact on interest rates. And interest rates are a key input for valuing the stock market. Last week's dip in the market is evidence of that linkage - the CPI was worse than expected and investors sold stocks.

Thus it makes sense that if there was a way to forecast inflation with some degree of accuracy, we could make better investment decisions. Where can we find such a forecast? The usual suspects, economists, government experts, the Fed, have a spotty forecasting record which could result in some nasty surprises. So we look to the market for help. Here is a chart of the spread between 10yr US Treasury TIPS (inflation protected bonds) and traditional 10yr US Treasury bonds.

The spread provides important insights into inflation expectations. When it is rising, the market fears accelerating inflation. When it falls, the market is expecting stable to falling inflation. Notice that this spread has remained in a narrow band for about three years. And at the moment it looks like the market is not expecting a worsening inflation situation. That's good news for stocks!

Why Earnings Growth Matters

In many of our posts, we report on the corporate earnings environment. It doesn't take a rocket scientist to understand the linkage between economic/business conditions and a corporation's ability to grow profits. Positive GDP growth, modest inflation, stable (falling) interest rates and benign government interference (e.g. taxes, regulation, etc.) should allow corporations to grow sales and profits. Negative GDP growth, rising taxes and regulation, unstable inflation/interest rates make growing profits very difficult indeed.

Why does this matter to investors in stocks?

The direction of earnings is perhaps one of the most critical factors to overall stock market health. A study by FTN Midwest Securities shows a very high degree of correlation (r=.83) between the direction of earnings and the market (in this case measured by the S&P 500). Simply put, when earnings go up the market tends to go up.

Surprisingly the same study shows that the pace of earnings growth is not correlated to the level of the market. So today's level of angst about slowing earnings growth may be over done.

Bottom line: Earnings growth matters. As long as the environment allows corporations to grow their earnings, even at a modest pace, the market should retain a positive bias. So while looking for slower earnings growth this year, we're still looking for a market advance.

CPI Runs Hot

After all the positive news over the past several weeks, today's report on the CPI was just a bit disappointing. Both the "headline" number of +0.2% and the "core" gain of +0.3% were above expectations and the prior three months levels. Of note, healthcare costs took a big jump - +0.8% - in January.

While not we're not happy with these numbers, we're not really concerned as one month does not make a trend break. We still believe inflationary pressures remain relatively mild and at a level the Fed can tolerate. Indeed it seems to us that we've entered a period of interest rate stability across the yield curve which should provide a favorable backdrop for the stockmarket.