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Stocks Yin to Bonds' Yang

Liz Rappaport

Chief financial officers are more optimistic than they were last quarter. Federal Reserve officials remain relatively unconcerned about the subprime mortgage market or a credit crunch. U.S. Treasury Secretary Henry Paulson says the economy is "solid."

It almost feels like thou doth protest too much kind of theatrics.

"Financial markets have been volatile, which imparts more uncertainty to the outlook," as Chicago Fed President Michael Moskow said in a speech Wednesday to the Jewish United Fund Luncheon in Chicago.

For stock traders, previously devotees to the so-called Goldilocks economy, the volatility and mixed economic data fill them with insecurity about where the market and the economy are headed. But for the bond market, the recent volatility and economic concern have refueled an already-pessimistic penchant for pricing in a Fed easing cycle.

Without solid assurance one way or the other, trading sessions are unpredictable and vacillating. The Dow Jones Industrial Average gained as much as 48 points intraday Wednesday, but finished in the red by 0.1% to close at 12,192.45. The S&P 500 closed down 0.3% at 1391.97, and the Nasdaq Composite closed down 0.4% to close at 2374.64.

The bond market rallied Wednesday, sending the yield on the benchmark 10-year Treasury note up 8/32 to yield 4.49% vs. 4.53% on Tuesday.

Justified or not, the fixed-income traders really can't get more pessimistic at this point, says T.J. Marta, fixed-income strategist at RBC Capital Markets. "The eurodollar futures contracts have priced in a full easing cycle -- 75 basis points of rate cuts by next June," he says. "We're only at 5.25% [fed funds rate]. Unless you're talking about a recession like 2000 with a strong dollar, the Sept. 11, 2001, terrorist attacks, and Enron and WorldCom bankruptcies thrown in, how can you get much more than 75 basis points?"

Meanwhile, the typically hawkish Moskow also said "it is much too early to say that inflation is no longer a concern," even as he admitted recent data have been "on the soft side."

In any event, the stock market has not rid itself of a rosier take. The complacency that kept the markets from a correction for so many months is largely still in place, says Barry Hyman, equity market strategist at EKN Financial. "All anyone I talk to wants to know is what to buy, not what to get out of."

On Wednesday, investors were bottom-fishing in some of the hardest-hit parts of the market. Subprime lender Fremont General (FMT Quote) jumped nearly 26% on reports it is in talks with five or six buyers interested in its mortgage business. Some of the homebuilders also were in the green Wednesday, including Toll Brothers(TOL Quote), Lennar(LEN Quote) and Hovnanian(HOV Quote). But news reports of D.R. Horton's(DHI Quote) chief executive Donald Tomnitz saying the rest of the year will "suck," put a damper on the sector's strength. Its shares slid a fraction on the day.

Oil prices were higher Thursday on news of shrinking inventories. Crude gained 1.85% on the day to $61.81 per barrel. Energy stocks followed suit. Exxon Mobil(XOM Quote), Chevron(CVX Quote) and Valero (VLO Quote) were among the sector's winners.

In the bond market, traders noted the new and improved ADP National Employment Report, which showed 57,000 private sector jobs added in the month of February. The report has been spotty in foreshadowing the Bureau of Labor Statistics' nonfarm payrolls report, but the new methodology may help put it within better striking distance of Friday's release.

Macroeconomic Advisers takes a larger sample, more frequently, and now breaks down the results by size of company payroll and by goods-producing or service sector. The goods-producing sector showed a 43,000 decline in new jobs, while the services sector revealed a 100,000 increase. The manufacturing industry itself showed a 29,000 loss.

RBC Capital markets' Marta says traders declined to trade on the report, but it "got traders ready for a sub-100,000 print." Analysts predict 95,000 new jobs in February.

The bond market may take a weak jobs report as more grist for the recessionary mill. The stock market may take it harder.

In this environment of shrinking liquidity, or at least the threat of shrinking liquidity, "the employment numbers become more critical," says Hyman. "That's what has been holding up the consumer spending patterns," a notion reinforced Wednesday by strong quarterly results from diverse retailers such as Saks (SKS Quote), Chico's FAS (CHS Quote) and Payless ShoeSource (PSS Quote).

However, "if you combine a slowing economy with job destruction and the housing market worries, then the slowing economic growth multiplies and you can have a 'one plus one equals three' story" in terms of the negatives adding up, Hyman says.

The Fed's beige book was mostly more of the same, though some attribute a slightly softer depiction of growth as part and parcel of the stock market's turn downward Wednesday afternoon. "Several Districts noted some slowing," read part of the first sentence. It also said "lending activity remained mostly unchanged."

Adding to the confusion is a report from Duke University showing that chief financial officers say they expect to increase capital spending, hiring and merger activity in the coming months. They expect earnings growth to slow due to rising healthcare costs and a shortage of skilled labor, but the "level of optimism about the U.S. economy continued to recover from a five-year low reached in September 2006," according to a press release.

In sum, the outlook is cloudy with chances of either rain or the sun breaking through. In other words, about as reliable as your average weather report.