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Thursday, 11 June 2009 05:11 Written by James Van de Voorde

The recovery in the stock market continued to gather momentum in May, with the Dow Jones Industrial Average, S&P 500 Composite and NASDAQ Composite up 4.07%, 5.31% and 3.32% respectively for the month.  Of these three important market barometers, only the Dow Jones remains negative for the year at –3.15%.  The S&P 500 is up 1.76% through the end of May, while the technology-heavy NASDAQ is up an even more impressive 12.51%.  A very good indication of the strength of this recovery, the S&P 500 is now trading above its 200-day moving average for the first time in 18 months!    

The stock market recovery has become impressive indeed, with the two-month performance during March and April the best since 1975 and the current 40%+ rally the biggest such initial bounce off of a market bottom in history.  Accompanied by better than expected profit reports and economic news far less dire than previously feared, the stock market is sending a strong message.  At the very least, the market is confirming that fears of the second coming of the Great Depression (that sent the market gapping down 25% as we entered 2009) were unfounded.  In this light, the recent market recovery can be seen as returning to recession equilibrium in V-shaped fashion just to take back the Depression trade.  This has been our call all along, even in the depths of the darkest days, and we are pleased to see the masses (and economists) come to our way of thinking.  We believe that the next leg up for the market will depend on the timing and strength of the actual economic data that ensues.  We expect that the market will remain in a trading range for the next few months with a bias for “buying the dips” as the economy transitions from “less bad” to “good enough”.   

Supporting our case that the trough of the recession will have been deemed to occur in the fourth quarter of 2008, GDP for the first quarter of 2009 was revised higher to a decline of 5.7%, up from the 6.3% decline in the fourth quarter of last year and slightly higher than the initial estimate of a 6.1% drop.  The consensus now forecasts GDP to be slightly negative in the second quarter, flat in the third quarter and slightly positive in the fourth quarter.  Other evidence of the recovery continues to mount.  The Conference Board’s Consumer Confidence Index surged in May.  Existing home sales rose by 2.9% in April and pending home sales in the U.S. shot up 6.7% in April, the biggest monthly gain in over 7 years, as the Realtors’ Affordability Index rose to a record high.  And while the unemployment rate rose to 9.4%, the 345,000 job losses in May were well below expectations and less than half the 741,000 jobs lost in January.  The gradually improving labor market is confirmed by the Challenger, Gray & Christmas survey, which indicates that announced corporate layoffs in May were 55% lower than in January.           

While these data points are encouraging, we still believe in the idea of a “new normal” where growth is hindered by a rising savings rate (less consumption), higher taxes, increased regulation, less leverage and lending capacity and a higher than desired unemployment rate.  GDP near 2% would be reasonable in this environment, with the market highly likely to favor those companies that can deliver consistent earnings and dividend growth and possess the ability to fund their expansion with free cash flow, not debt.     

The number of investors that missed this initial bounce off the lows and the extraordinary level of cash earning next-to-nothing in money market funds will provide an ample supply of buying power for the inevitable dips.  In staircase manner, we expect a series of higher lows as the market climbs a wall of worry that seems to grow taller by the day, even as the market works its way higher.         

The increasingly clear message of the stock market has been further confirmed by the bond market.  The yield on 10-year Treasury bonds has catapulted from just over 2% during the peak of the crisis and ensuing “fear bubble” to just under 4%, with an amazing 120 basis point spike since mid-March alone.  As the markets become increasingly convinced of the non-existence of any deflationary “black hole” and gradually become open to the possibility of economic recovery, investors that previously sought the “safety” of Treasuries will sell them and search for higher yielding alternatives.  At the very least, the bond market is sniffing out an eventual economic recovery.  However, if we listen close enough, we believe the bond market is telling us of additional concerns that may lie on the horizon.                   

In a recent testimony before Congress, Fed Chairman Ben Bernanke summed up the potential message of the bond market by proclaiming the imminent end of the recession, but also calling for a “strong commitment to fiscal sustainability in the longer term” or risk “having neither financial stability nor healthy economic growth”.  Bernanke and the bond market realize that the United States must control its long-term deficits or risk a significantly weaker dollar, higher inflation and higher interest rates. On the one hand, the fact that the bond market is worrying about inflation means that the Federal Reserve has won in it’s short-term battle to avert the “very, very serious calamity” of deflation, as Bernanke described during his testimony.  On the other hand, the recent rise in interest rates has the potential to thwart the housing and overall economic recovery in its tracks, given the severity of the recession that we are just now working our way through.

With the potential inflationary impact of the coordinated multi-trillion dollar campaign by the Federal Reserve and its escalation to quantitative easing combined with the Obama administration’s stimulus package, the bond market and so-called “bond vigilantes” are serving to send rates higher (and a strong message to our nation’s leaders) even as the Fed Funds rate remains at zero.  Though the Fed’s intentions are to keep interest rates low for an extended period, they have very little control over bond traders that sell Treasuries out of disdain for our government’s seeming lack of fiscal discipline.

Remember, all of the aforementioned data and “green shoots” that point to economic recovery have occurred well before the Obama stimulus package kicked in.  In fact, as of May 22, only $36 billion of the total $787 billion stimulus package had been disbursed – that’s less than 5%.  And the core personal consumption deflator, the Fed-preferred measure of inflation, rose by a higher than expected .3% in April.  By this same measure, inflation actually accelerated at a 2.5% annualized rate between December and April.  Even if this proves to be an anomaly, it strongly suggests again that fears of deflation were way overblown.  So, inflation, while still low, has been much higher than the market and our political leaders anticipated.  And the economy’s ability to mend itself pre-stimulus is giving the bond vigilantes pause about what may happen when the stimulus goes into full force.

Bernanke’s recent speech indicates a Federal Reserve that is unlikely to do more to help bring interest rates down (i.e. will not increase its quantitative easing campaign) and instead will pressure the Obama Administration to reduce spending and to get our deficit under control.  Since neither the Fed nor the Obama Administration wish to risk stopping the economic recovery cold in its still-fragile infancy, we are hopeful that the Obama team will get the message the bond market is sending.  Nationalized health care seems highly unlikely if the bond vigilantes have their way.  And we may even see a means-tested great compromise for Social Security from the Obama Administration in order to appease the bond traders.  

We are keeping an eye on interest rates and considering several investments that might serve as a hedge in a potential world of rising inflation and a weaker dollar.  However, we must be mindful that stocks of companies that have demonstrated the ability to increase earnings and raise dividends year after year have historically been the best hedge against inflation.  The fact that these companies earn a growing majority of their earnings from foreign sales will give these investments an additional  boost should the dollar weaken further.

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