Stocks at record highs as Treasury yields fall

If all economists were laid end to end, they’d never reach a conclusion. – George Bernard Shaw, Irish playwright

In a holiday-shortened week that was characterized by low trading volume, stocks continued their ascent with additional gains as the major broad-market indexes hit record highs. This good news occurred despite the fact that revised first quarter GDP showed that the economy actually contracted by 1%, a victim of an unusually cold and harsh winter. This negative GDP, however, was mostly the result of a slower pace of inventory accumulation and should be reversed in the second quarter. But this weakness is in the past and markets tend to be forward-looking, choosing instead to focus on more recent data that indicates that growth should accelerate and the economy should improve. In fact, most economic data released last week was positive, including lower jobless claims, higher durable goods orders, higher home prices and higher consumer confidence readings. All of this data is further proof that the labor and housing markets as well as the manufacturing sector are steadily improving and should lay the foundation for better corporate profit growth in the second half of the year. While this seems to be the consensus view among most economists, consensus thinking can often be wrong and lead to unexpected outcomes. For now, stocks are trading higher on this optimistic view in the hope that future economic data confirms this positive market sentiment.

Last Week

According to the S&P Case-Shiller Index, prices of single-family homes rose almost 1% in March and have risen over 12% in the last year. Lower mortgage rates should continue to bolster the housing market. Durable goods orders were strong in April, boosted primarily by large orders for defense equipment. It appears that U.S. business investment is gaining momentum, which should be another positive sign for the economy. Although first quarter GDP contracted by 1%, consumer spending rose over 3% in the quarter, an encouraging sign as consumers actually reduced spending in April for the first time in a year. Most of this reduction was due to less money being spent for utility bills.

The yield on the 10-year Treasury reached a low for the year of 2.44%, confounding many bond strategists and economists who believed that a stronger economy with better jobs growth would lead to higher, not lower interest rates.

For the week, the Dow Jones Industrial Average rose 0.7% to close at 16,717 while the S&P 500 Index gained 1.2% to close at 1,923. The Nasdaq Composite Index increased 1.4% to close at 4,242.

This Week

The most important piece of economic data this week will be the May employment report, which is expected to show that non-farm payrolls increased by about 220,000, a number that could convince skeptics that the economy is turning the corner. The unemployment rate is expected to tick up slightly to 6.4% from 6.3%. Other data of importance include the Institute of Supply Management (ISM) manufacturing index for May, which is forecast to show healthy expansion in the sector, and automobile sales in May, which are expected to be strong.

The European Central Bank (ECB) will hold a meeting to address monetary policy and it is widely predicted that further stimulus will be applied to their economy in the form of still lower interest rates to help spur economic growth.

Among the more familiar companies on the earnings calendar this week include Jos. A. Bank Clothiers, Dollar General, J.M. Smucker and Joy Global.

Portfolio Strategy

An example of how the consensus can be wrong has never more evident than the forecast of most economists at the start of the year that the 10-year Treasury yield would steadily rise, from 3.0% at year-end to 3.25% at mid-year and 3.50% or higher by the end of 2014. Instead, Treasury yields have fallen like a rock through the 2.50% level and have left economists scratching their heads, looking for an explanation as to why. Part of the reason has been low yields in Germany and France, where comparable government bonds yield less than 2%, making U.S. bonds seem all that much more attractive by comparison. Other reasons cited include sluggish economic growth, an overall shortage of bonds, expectations of further European rate cuts, short positions in the Treasury market and underweighted fixed income allocations in portfolios. While the most plausible reason seems to be the lackluster economy, until there is strong and irrefutable evidence that better economic growth is sustainable, bonds are likely to provide stable and consistent income with little or no volatility. And if the economy doesn’t improve as forecast, it is stocks that could be vulnerable.