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June 7, 2007
Pessimism Coagulates
Having successfully traversed a bout of financial market volatility in late February/early March, U.S. equities have been a tear ever since. And although the gains have not been as spectacular as the ‘record high!’ cheerleaders have made them out to be, that the Dow has managed to gain nearly 10% in 2007 is nonetheless impressive.
That stock prices have rallied even as the U.S. economy slows down can be explained by the fact that corporate earnings have arrived well ahead of expectations. Even the more stringent profit measure from the BEA says that profits are still rising on a year-over-year basis.
Having been wrong - at least in their timing - about the threats rising commodity prices, peak profits, and a slowing U.S. economy would have on stocks prices, bears have not been quick to switch their focus. Rather, beyond vague speculations about an excessive amount of ‘liquidity’ in the marketplace and/or waiting for the next hedge fund collapse, the bear case has been spinning aimlessly in recent weeks. That is, until now:
Fed rate cuts gone - a hike may be coming CNN
Stocks Plunge on Inflation Concerns AP
Rising interest rates on the long-end of things could cause further damage in the already damaged U.S. housing market, making it especially difficult for ARM resets to avoid defaults later this year. As for the inflationary threat - highlighted today by a larger than expected jump in unit labor costs – it continues to defy the slow down in the U.S. economy and, if not contained, could ravage profit margins. Yes, there are countless other equity evils that can be correlated to rising interest rates, but housing and margins are the two worth highlighting today.
Fixated on The Fix
For a brief period in 2007 bad economic news meant good news on Wall Street: a slumping economy meant the Fed was soon going to cut interest rates. And although it is impossible to quantify how much mileage stocks have racked up based on the expectation for a Fed rate cut, it is safe to say that pessimism can ride rising interest rate fears for as long as the trend remains in play. To be sure, as biased as the pro-equity analysis has been in recent weeks, nearly all of it has played-up the fact that equities are the preferred asset in a low and/or falling interest rate environment - models do not take kindly to rising interest rates.
As for the Fed, they may still cut interest rates before year end, but, as of this moment, they would likely only do so in response to a financial market crisis, not because of economic weakness. Unfortunately for the optimists, new capital opting for the safe returns in fixed instruments versus the unpredictable returns in stocks is not a crisis so long as inflationary pressures remain slightly higher than the Fed script.
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