Innovation Update

Return to Article

What a Week: Shifting the Paradigm

Liz Rappaport

Traders spent most of January pricing in strong growth and low inflation. This week the Federal Reserve itself endorsed the Goldilocks tale.

The Federal Open Market Committee kicked off the year with a paradigm shift in its policy statement. Put simply, the Fed said growth got stronger and inflation got weaker. But the central bank kept rates steady and retained its tightening bias.

The Fed warned of wage inflation, but Friday's nonfarm payrolls report shoved off any immediate threat. With a weaker-than-expected 111,000 addition of new jobs, average hourly wages rose 0.2% to a 4% year over year pace -- lower than December's scary 0.5% jump and 4.2% year-over-year pace.

"Real growth is better than most expected, and inflation is better than most expected," says James Paulsen, chief investment strategist at Wells Capital Management. "That puts the Fed in a holding pattern, and you can't think of a better world for stocks."

Such satisfied contentment powered the Dow Jones Industrial Average, the Dow Jones Transportation Average and the Russell 2000 to new highs during the week. The Dow came off the boil Friday, dipping slightly on more than 1% losses in Boeing(BA Quote), Alcoa(AA Quote) and Microsoft(MSFT Quote). But on the week, the blue-chip index jumped 1.3%, the S&P 500 added 1.8%, and the Nasdaq Composite jumped 1.7%.

The Dow Transports ended the week up 6.2% to close at a new record high for the first time since last May. The index finished the week at 5006.89.

Proponents of Dow Theory have been waiting for the Transports to confirm the Dow Industrials' new highs in since the latter set an all-time high in October. Now that the Transports have reached a new peak, some contrarians might wonder if it's a sign of the best news coming at a market top.

Indeed, the week also included a hefty new issues calendar during which eight initial public offerings priced, according to Briefing.com. In other frothy news, Japan's benchmark index, the Nikkei 225, reached a new 52-week closing high Friday as well.

"One concern is that there is more optimism about the stock market than there was one or two years ago," says Paulsen. "You wonder if this entices more cash into the game." He adds that a selloff of 2% would scare those late-to-the-party investors away, providing another nice buying opportunity.

Dancing to the Data

The data surrounding the FOMC statement on Wednesday included the government's first estimate of fourth-quarter GDP growth at 3.5%. The economy roared with a boost from exports and retail spending in the face of a continued drag from the housing market. Housing activity declined 19.2% -- the weakest quarterly showing since 1991.

The Fed, which had focused on housing as a key concern through December, apparently came around to many traders' point of view that the worst is behind us, a view supported by Standard Pacific's (SPF Quote) upbeat outlook Friday. Reflecting the recent rise in home sales and declining inventories, the Fed statement read: "Recent indicators have suggested somewhat firmer economic growth, and some tentative signs of stabilization have appeared in the housing market."

Personal consumption data streamed in to show that incomes are rising and that people are spending their winnings. At the same time, the Fed's core personal consumption expenditures index revealed fading price pressure. Manufacturing activity as measured by the ISM was soft, but that weakness was already priced in, say traders.

"This is the fox-trot economy," says Jeffrey Saut, chief equity strategist at Raymond James & Associates. "Fast, fast data followed by slow, slow data." Saut notes that while payrolls for January were weaker than expected, factory orders were higher. Payrolls for January were weak, but revisions to prior months show that jobs grew more than analysts' expected over the past three months.

The fed funds futures market took the sum of the parts and put odds of any move in the overnight borrowing rate to neutral until the fall. With only 1% odds of a cut in March and May, the fed funds futures market prices in 66% odds of a cut by the end of the year, according to Miller Tabak.

Likewise, the bond market somewhat unwound last week's strong reaction to recent signs of economic growth. With the temperate inflation data, traders removed some of their rate-hike fears and sent yields down slightly. The 10-year benchmark Treasury bond fell to 4.82%, from 4.88% last week.

As equities soared to new highs, the old leadership came back, notes Paulsen.

The Russell 2000's all-time high spotlights the resilience of small-cap stocks. And cyclical companies likewise had a strong week. The Morgan Stanley Cyclical Index jumped 2.8% on the week, while some of its components fared even better: Caterpillar(CAT Quote), Deere(DE Quote), FedEx(FDX Quote), and Ingersoll-Rand(IR Quote) jumped 4.8% to 6.8%.

Overall, earnings strength is on pace with prior quarters as 64% of S&P 500 companies have beat expectations, 16% have matched, and 20% have missed, according to Thomson Financial. At this point, earnings are set to put in another quarter of double-digit growth -- at 10.4% -- but guidance is weaker than in prior quarters.

The ratio of S&P 500 companies that have provided positive preannouncements to those with negative preannouncements is 4.5 to 1, higher than the average 2-to-1 ratio, says John Butters, an analyst at Thomson.

Key to whether the post-Fed rally can extend into next week is the fourth-quarter productivity data out on Wednesday. Analysts expect 1.7% productivity growth, up sharply from the weak 0.2% rise in the third quarter. The report also includes the fourth-quarter unit labor costs. Productivity gains absorb the inflationary pressure of wage increases. Next week also includes the Institute for Supply Management's report on service sector activity.

Whatever next week's data, the market-moving drama comes in two weeks when Federal Reserve Chairman Ben Bernanke gives his semiannual testimony to Congress on the state of the economy. Given the recent figures, he's unlikely to veer from the new, more neutral script -- a shade of beige the financial markets were quite attracted to this week.