Tug of war between bulls and bears

One of the funny things about the stock market, every time one is buying another is selling, and both think they are astute.

-William Feather

 Both bullish and bearish investors can make their case for whether or not stocks will continue to rise or fall by looking at the current level of interest rates. For bulls, stocks are cheap relative to bond yields and should continue their upward rise. For bears, relatively low interest rates have persisted for such a long time that their inevitable climb will likely derail any stock rallies. Who’s right? Time will tell, but studies on the correlation between stock prices and 10-year Treasury yields have shown that stocks are negatively impacted when the Treasury yield is 6% or higher. Although the current 10-year Treasury yield is only about 2.50%, its sharp rise from 1.60% in May has certainly got the attention of stock investors.

Last Week

 For the most part, the economic data released last week was favorable and enabled stocks to regain some of the losses suffered from the prior week. New home sales hit a nearly 5-year high as did U. S. consumer confidence. U. S. durable goods rose 3.6% in May while consumer spending and personal incomes also rose by 0.3% and 0.5%, respectively. Continuing the drumbeat of good economic news were pending home sales, which rose 6.7% to a 6-year high in May and consumer sentiment, which declined slightly in May but remained close to a 6-year high.

 The only downbeat piece of economic data announced last week was the revised 1^st quarter GDP report, which was lowered to 1.8% from 2.4% due to weaker consumer spending, weak business investment and declining exports. Since consumer spending accounts for more than two thirds of economic activity, this report is definitely a worrisome sign. However, instead of treating bad news as bad news, Wall Street viewed this bad news as good news and stocks actually rallied and closed higher on the day. The rationale being that the Federal Reserve would likely delay any tapering of the stimulus program and keep the monthly bond-buying in place for the foreseeable future. Only in the stock market could perceived bad news be considered good news.

For the week, the Dow Jones Industrial Average climbed 110 points or 0.7% to close the week at 14,910. The S&P 500 did slightly better as it rose 13.85 points or 0.9% to close at 1,606. For the first half of the year, the Dow is up 13.78% while the S&P 500 is up 12.63%. The last time the Dow rose by at least this much was way back in 1999.

 This Week

The all-important June employment report will take center stage this week with release of the unemployment rate and non-farm payrolls number on Friday. With the 4^th of July holiday the day before and many traders on vacation, this closely watched indicator could lead to an increase in volatility. Estimates call for about 165,000 new jobs to be created in June and for the jobless rate to dip slightly to 7.5% from 7.6% last month. Given the significance of the unemployment rate in determining the Fed’s policy making going forward, all eyes will be focused on this number and its effect on any future tapering plans.

Also due out next week is the ISM manufacturing index, which is expected to show modest improvement. In Europe, the European Central Bank is scheduled to make a policy announcement on Thursday, most likely reiterating its highly accommodative monetary policy and no change in its policy to keep interest rates low.

 On the earnings calendar next week, American Greetings and Constellation Brands highlight a very slow week for company reports in contrast to the following week, when the earnings season really begins in earnest.

 Portfolio Strategy

 Both the stock and bond markets will likely be held hostage going forward by the continued uncertainty over the timing of the Federal Reserve’s plan to reduce its monthly bond-buying program. Last week, New York Fed President William Dudley tried to calm investor fears that the stimulus would be withdrawn sometime soon. He said that it might even increase if the labor market doesn’t improve. Noted bond fund manager Bill Gross of Pimco Asset Management echoed these sentiments and said that bond prices have likely stabilized for now and represent excellent value at these levels. Indeed, yields have risen about three-quarters of a percentage point or more in both the taxable and municipal bond market since early May. With a benign inflation outlook and a steep decline in commodity prices, yields are attractive for fixed income investors. The 10-year Treasury Note yields 2.5%, up from 1.6% in May; the average junk bond yield is 6.75%, up from 5% and a 10-year, AAA-rated municipal bond yields 2.6%, up from 1.65%.

 It’s highly unlikely that stocks will see the same returns in the second half of the year. With the average stock fund up 13% through June 30^th, equities will probably be range bound over the near-term. The upcoming earnings season obviously looms large as well as any changes in central bank policy and their effect on interest rates. Stocks are neither overvalued nor undervalued and will likely enter a period of consolidation. Earnings for the quarter are forecast to rise only about 3%.

For investors with exposure to commodities and emerging markets, it’s been a difficult year as both asset classes are down by double digits. Slowing emerging market economies have lessened the demand for commodities and, as a result, the price of gold, silver and other precious metals has fallen. Allocations to these investments in portfolios have been minimal, though, and the long-term outlook remains favorable.