The Recovery Rally Continues
by Paul J. Nolte, CFA
April 26, 2010
How creative do we have to be after eight consecutive weeks of a positive market to make this week more interesting than the last eight? Earnings continue to be a bit better than expectations, Greece is still trying to get funded and the economy is still bumping along. So with the so-so backdrop, why does the market continue to march higher? It is the only game in town! Short-term interest rates continue to be held near zero (we’ll hear more this week) as the Fed worries about the frailty of the economic recovery. Inflation, as reported last week, remains high, however much of the gain is in food/energy prices (the stuff we never buy!). So one of the major questions facing the Fed this week and over the next few meetings will be reconciling the weak economy and higher headline inflation reports. Weak economic data still is showing in the housing market, even though the seasonally adjusted gain in sales was huge – mainly due to the expiring tax credit, which we saw last November. As the government tries to gracefully exit the various programs designed to prop up the economy, the major question on investors minds will begin to be answered: can the economy stand on its own two feet?
The market is and remains in overbought territory, meaning a correction can come out of nowhere and push the averages lower by at least 3-5%. At best, we are hoping for a frustrating sideways market to work off the excessive bullishness that has built up during the two-month rally. We are still expecting stocks to work higher through the summer months or at least until the Fed decides to pull back on their zero interest rate policy. Investors are beginning to feel as though they understand the rules of the game that is the stock market – anytime the markets decline for more than a couple of hours, begin buying. The markets have increased an astonishing 71% of the time just since early February and the equity surrogate for the SP500 (SPY) has increased an amazing 27 times in the past 30 weeks. In fact, if Monday’s returns were deleted from the market returns since late September, the markets would have declined by just over 6% vs. the current gain of more than 15%, an indication of the persistent strength in the market (see:http://www.bespokeinvest.com/thinkbig/2010/4/20/tgim.html). Our call is for more of the same, until it ends! For a persistent decline to evolve, the markets would have to continue higher without the support of the majority of stocks, which is currently not the case.
The bond market will be dealing with the Fed meeting this week (expect more of the same) and the auction of 2, 5 and 7 year notes that could put upward pressure on rates to get them sold. So far, our model remains bullish and is indicating that conditions are right for a decline in bond yields in the weeks ahead. Given the Fed is likely to keep their zero rate policy in place, with comments very similar to past meeting (indicating the economy is still early in the recovery phase), we do not see pressure on rates to push them higher. While inflationary pressures seem to be building, much of it is focused on food and energy (remember $150bbl oil?), while many other facets of the economy struggle to generate pricing power. As long as the 10-year bond stays below 4-4.25%, we feel comfortable holding longer-term bonds.
© 2010 Paul J. Nolte, CFA
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.