Things remain positive in the U.S. Labor market data (jobless claims) beat estimates again as both labor market and credit market data continue their four-five month trend of improvement. That helps to explain both rising consumer confidence and last week's report of improving retail sales (sales were up for the second straight month). Notable in the retail sales data was an increase in building materials sales, which is a good sign for housing (Wells Fargo Securities). On the less impressive side of the ledger was Friday's industrial production report, which indicated that industrial production was essentially flat in February despite strong reports from regional indices in New York (Empire State Manufacturing Index) and Philadelphia (Philadelphia Manufacturing Index). My sense is that the industrial production report probably reflects a temporary fall-off of orders that were accelerated into the fourth quarter of last year, before the 100% expensing of capital purchases expired at year's end. If so then it should be a temporary softening. This is consistent with the Fed's FOMC (Federal Open Market Committee) meeting notes last Tuesday, which reported that the economy continues its modest expansion with improving labor market conditions, household spending, and business fixed investment. The Fed also recognized that "strains in the global financial markets have eased" (Federal Reserve). I think the stock market has reflected this.
Are stocks headed for a pull-back? Probably. The S&P 500 has gained over 20% over the past five months, one of the longest and strongest uninterrupted rallies on record (GaveKal). Pull-backs are "expected but not predictable," in my opinion. U.S Treasuries have done well too, as bond prices are up 20% over the past year. And according to Hong Kong-based GaveKal, this bond market gain is far more rare than a five-month, 20% rally in equities. Equities have gained 20% in a year or less eight times over the past 20 years, while bond prices have only achieved this once. The equity gains were "generally followed by nothing more painful than a slowdown," while the bond markets, in contrast, were followed by pretty memorable "bond meltdowns" whenever they got in the range of a 15% annual gain (1994, 1999, 2003/4, and 2009).
That's not to say that we expect a bond market collapse, but we do expect interest rates to rise as the economy expands and credit markets continue to normalize. Rising rates means lower bond prices, but some of the recent demand for bonds (which has led to high bond prices) is probably more permanent than transient. For example, today's higher savings rates (relative to the 2007/08 crisis) translate into "preservation and protection," which means bonds, and more people are owning bonds as insurance against equity market losses. There has also been a lack of speculative buying in bonds, and speculative buying is a key characteristic of asset "bubbles." Finally, regulators are pushing banks and insurance companies to own more bonds. We continue to see high quality municipal bonds as being in the sweet spot for safety and yield.
Bonds and stocks: But GaveKal also points out that, of the seven serious bear markets in bonds since 1982 (involving losses of 15% to 20% in 30 year Treasury prices), "not a single one of these major bond corrections has caused a bear market in equities." Two have coincided with flat equity markets, while five have coincided with big equity gains. That's consistent with research at Credit Suisse, which argues that the currently elevated equity risk premium should put a floor on any correction that might occur in the equity market, meaning most bad news is already priced in. That might seem strange after such a sharp run-up in stocks, but remember that the market was trading in its current range (S&P 1400) ten years ago, even though the earnings and cash flow generation since then has been tremendous. So valuation levels are lower than they were in the past.
Finally, STMM's Financials sector specialist, Jay Hammond tells me that the Fed completed its annual bank stress tests last week ("Comprehensive Capital Analysis and Review"), which tests banks against severe economic scenarios in order to see if they can maintain minimum regulatory capital requirements or ratios. 18 of 19 companies passed, which was expected, but the results were much stronger than anticipated. The Fed's assumptions were much stronger than previous tests - an 8% GDP decline, 13% unemployment, 52% stock market decline (from Q3 2011), 20% housing decline, and severe global macroconditions.
Posted on Mon, March 26, 2012
by Jim Kee, Ph.D.