Amid a few hair-raising events -- the
brief case of amnesia about inflation,
debt getting slapped with junk status and a huge uptick in April employment -- the market managed to post its third straight week of gains.
For the week, the
Dow Jones Industrial Average
added 1.5% to 10,345.40. The
advanced 1.3% to 1171.35, and the
rose 2.4% to 1967.35.
After too many calls for a rebound proved premature, the market's recent uptrend has not been trumpeted too loudly by weary investors. But after months of discounting slower growth, creeping inflation and a tightening Fed, this week may offer an opportunity for important shifts in underlying market trends.
By Friday, the strong uptick in April employment went a long way in easing concerns about the extent of an economic slowdown. Investors have so far played the "soft-patch-or-worse" scenario by ditching cyclical issues from their portfolios in favor of defensive sectors such as utilities, consumer staples and health care.
But if the latest jobs report is a real indication of economic resilience, it would seem that a revision of this investment strategy is in order. This "lends support to our thesis that investors should get more aggressive in their equity allocations," Prudential market strategist Ed Keon wrote to clients, recommending more allocation into growth proxies such as energy stocks.
The case resonates louder as the Dow is now up 3.3% and the S&P 500 is up 2.9% from lows made at the close of trading on April 20. The Nasdaq, which has trailed behind year-to-date, is also up 3.3% from its closing low made on April 28.
The market's negative performance had turned dismal in April after the weak March employment and evidence of softer consumer spending and confidence. The resulting "wall of worry" should therefore create a good opportunity for investors, if the slowdown was indeed just a soft patch.
"As I see it, financial markets already discount slower growth, so even a moderate rebound could have important implications," says Morgan Stanley chief U.S. economist Richard Berner.
A forensic analysis of the slowdown, he says, may provide clues on how investors should position themselves for the balance of the year. Was it mostly driven by consumers, weary of soaring energy prices, buying less, in turn leading businesses to accumulate inventories and cut back on employment?
If that's the case, and if oil prices remain range-bound or trend lower, there's a case to be made for a consumer comeback and for a return of consumer cyclical stocks.
According to Berner, businesses also cut back on capital spending in the first quarter, mostly because of the end of capital expenditure tax incentives last year. Spending slumped in the first quarter as real equipment outlays rose only 6.9% compared with 18% in the second half of 2004. But capex should return to normal after the first quarter's unwinding, Berner says. This would also make a case for a comeback in cyclical stocks.
Of course, many headwinds remain; for instance, crude prices rose 2.5% this week and moved back above $50 per barrel. In addition, businesses accumulated $80 billion worth of inventories in the first quarter. Drawing them down should slow production and employment somewhat.
More importantly, what will be the ongoing impact of gasoline prices and of higher interest rates on consumers? What of the future direction of energy prices, inflation and interest rates?
On that note, the Fed, after delivering its eighth quarter-point rate hike in a row Tuesday, made clear that inflation remained clearly in its crosshairs.
Alan Greenspan & Co. apparently forgot to include the usual reference that "long-term inflation expectations remain well contained." The Fed, in an unprecedented move, corrected the statement late in the trading day. But another sentence featured in past policy statements, referring to the so-far negligible impact of energy prices on core inflation, never made it back into Tuesday's statement. The April employment report, which included faster-than-expected average hourly wage growth, will also go a long way in putting labor markets back in the center of inflation concerns.
Thursday brought additional evidence that employment costs continue to rise due to higher health care and energy costs, even as productivity continued to rise in the first quarter.
The employment cost index, released last week, showed a much tamer wage picture. But according to Goldman Sachs economist Ed McKelvey, the fact that the Fed failed to mention this in its statement Tuesday points to overarching concerns about labor costs. Of course, the Fed may have just forgotten.
Rising labor costs may also, of course, eat into corporate profits. Few might be as aware of this fact as General Motors. Standard & Poor's, unconvinced by GM's ability to straighten itself out, finally cut the automaker's debt rating to junk on Thursday. S&P also took down
rating. An offer by billionaire Kirk Kerkorian to double his stake in GM's stock also failed to convince S&P.
The S&P downgrades sent shock waves through the corporate bond market. The resulting flight to quality into Treasuries helped push the yield of the 10-year note back to 2 1/2-month lows of 4.15% on Thursday.
But Friday's employment report pushed the yield of the 10-year bond back up to 4.26%, up 6 basis points for the week. And the Treasury department hinted at the reintroduction of the 30-year bond, which should also help make the 10-year more susceptible to shorter-term inflation concerns.
Both Bank of America's Tom McManus and Sanford Bernstein's Vadim Zlotknikov believe that higher rates, waning consumption and a deceleration of corporate profits will be dominant trends in this year's market. They still both allocate the majority of their portfolios in utilities, health care and consumer staples.
McManus, long convinced that higher bond yields are on the way, backs overweight positions in "inflation beneficiaries," such as energy and materials stocks, and underweight positions in interest-sensitive sectors, especially those dependent on consumer spending.
Zlotnikov, as mentioned
here Thursday, also believes that growth this year will be mostly on the corporate spending side of the economy, not on the consumer side. He advocates a few industrial cyclical stocks, such as
, but only as long as the market does not buy a full economic recovery scenario.
In keeping with TSC's editorial policy, Godt doesn't own or short individual stocks. He also doesn't invest in hedge funds or other private investment partnerships. He invites you to send