Bulls Break Out the Bubbly

The Dow hits another record and the S&P and Comp jump as rising optimism meets ample liquidity.
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On Main Street,

Wal-Mart

(WMT) - Get Report

is suffering. On Wall Street, the stock is up.

The disconnect represents the larger paradox about the current stock market -- that it keeps going up even as the economic slowdown grows more obvious. There is tremendous excess liquidity in the financial markets fueling a rise in virtually every type of market, but not much excess liquidity in the hands of many consumers. As the holiday season approaches, the stakes run high for the consumer, the economy and the retailers servicing them.

For now, "this is a stock market that can't turn down," says Randy Diamond, in sales and trading at Miller Tabak, recalling the opposite phenomenon occurred in 2003 when the market was at its low and had a hard time turning up even though fundamentals and the economy were improving. Here we have no clear view of how hard the economy will slow, bullish sentiment running high, and the market can't stop rising.

Any trader's next breath, however, brings the question of whether the surge is yet another sign of a market top. "We're going to get a blow off here," says Diamond, who notes the gains came on below-average volume.

The three major stock indices spent most of the day in the red, until late afternoon when the

S&P 500

turned up and broke through 1389, its Oct. 26 closing high. The breakthrough caused a rash of short-covering, and buyers who rushed in to send all the indices soaring.

The

Dow Jones Industrial Average

recorded another record close, gaining 0.7% to 12,218.01. The S&P 500 marked a new six-year high, closing up 0.64% at 1393.22, and the

Nasdaq Composite

gained 1.01% to close at 2430.66, its highest level in more than five years.

"It's an old adage, 'never short a dull market,'" says Michael Driscoll, director of listed trading at Bear Stearns. In addition to short-covering, there is lot of "nervous cash" out there chasing performance, Driscoll says, adding that St. Louis Fed President William Poole's comment that monetary policy was "about right" also gave traders a reason to buy.

Oddly enough, it was the most sensitive sectors leading the market Tuesday. Retailers and homebuilders bucked the day's downward trend from the get-go. Shares of Wal-Mart were up all day supporting the Dow, despite the retailer missing analysts expectations for its third-quarter sales. The report followed weak October sales figures and a forecast for weak November sales as well. To top it off, the company also said it would offer aggressive price cuts to fight for a strong holiday season. Still, Wal-Mart shares gained 2.9%.

Shares of other retailers joined in the pre-holiday party, as

J.C. Penney

(JCP) - Get Report

,

Kohl's

(KSS) - Get Report

and

Target

(TGT) - Get Report

, which beat analyst expectations, were also up 3.10%, 1.32% and 2.42% on the day.

Shares of

Home Depot

(HD) - Get Report

were also up 4.3% despite the home-improvement retailer reporting weaker-than-expected results. Meanwhile, shares of several homebuilders gained on the back of

D.R. Horton's

(DHI) - Get Report

better-than-expected earnings and another drop in Treasury yields amid the weak economic news.

D.R. Horton's shares gained 9.47% on the day, while competitors

Centex

(CTX)

and

Pulte Homes

(PHM) - Get Report

gained 3.9% and 5.05% on the day. The 10-year note rose 10/32, its yield falling to 4.57%, just four basis points above its low for the year.

Homebuilders and retailers gained ground against the backdrop of a better-than-expected, but still declining, retail sales report. Retail sales fell 0.2% in October, when analysts had expected a 0.4% drop. Excluding auto sales, retail sales fell 0.4%, worse than the 0.3% decline forecast by economists. Excluding gasoline, which saw the sharpest drop, retail sales gained 0.4%.

Lower gas prices skewed overall retail sales to the downside in October, but that extra cash didn't show up boosting overall retail sales. So where did people go with their gas money?

"There is good reason to believe that rational consumers now need to shift back to income-based saving strategies," writes Stephen Roach, chief economist at Morgan Stanley. And if consumers are saving and not spending, that does not bode well for the holidays or for economic growth in the next few quarters, says Roach.

Could it be that Americans are taking their rising wages and socking them away for a rainy day?

Maybe some of them are socking their funds away for their adjustable-rate-mortgage payments and home-equity-loan payments as the refinancing phenomenon has removed huge chunks of wealth embedded in their homes. Indeed, between 2003 and 2005, home owners extracted $150 million more in equity from their homes than they did in the previous eight years combined, according to a report published Tuesday by Demos, a New York based public policy research and advocacy organization.

Demos says that between 1973 and 2004, average home equity fell to 55% from 68.3%, and that in 2006, American families' percentage of monthly income to debt payments reached a record 19%. In the meantime, $400 billion of adjustable-rate mortgages, or 5% of all outstanding mortgage debt, resets this year for the first time, while another $1 trillion resets in 2007.

With long-term interest rates still low, and housing prices falling from such extremely high levels, the damage could be somewhat contained. But it is unrealistic to expect defaults and foreclosures won't increase.

While consumers find themselves stretched, cash balances in the business world and financial markets remain elevated. Credit spreads remain tight, companies are buying back stock in record amounts and institutional investors still haven't put all their cash to work.

Fund managers' average cash balances have risen to 4.1%, from 3.8% in October, as 21% of fund managers took overweight positions in cash, according to the Merrill Lynch Survey of Fund Managers for November. The number of fund managers reporting higher risk appetite more than doubled in the month. Fund managers reported anxiety about how much farther corporate profits could grow, but suggested they expect the Treasury yield curve to steepen, which reveals a bias to expect rate cuts rather than rate hikes.

Tuesday's inflation data was friendly to the rate-cut theory as the producer price index fell 1.6% and the core PPI fell 0.9%, distorted by a sharp decline in vehicle prices.

Indeed, odds of a rate cut are up slightly Tuesday, with a 4% chance of cut at the January meeting and 24% odds of a cut in March, up from 18% on Monday, according to Miller Tabak. For the May meeting, the market prices in 74% odds of a rate cut, up from 66% Monday.

The danger in the disconnect between financial markets' liquidity and real economic pressures on U.S. consumers is that the market can lose its forecasting ability, says Scott Frew, partner at hedge fund Rockingham Capital Partners.

If we're to believe stocks, the economy is heading for a soft landing. But if we're to believe bonds, the economy is headed for recession. It could be that both markets are simply showing the signs of excess liquidity and not much about the "real" economy.

In keeping with TSC's editorial policy, Rappaport doesn't own or short individual stocks. She also doesn't invest in hedge funds or other private investment partnerships. She appreciates your feedback. Click

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