What a Week: End of Long Bond Has Bulls Primed

The question now is whether all the bad economic news is really behind the market.
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If ever a week proved the stock market is a "discounting" mechanism, this was the one. By focusing on the hope for better economic times ahead, major averages were able to largely "discount" some unmistakably negative economic news, a debt default in Argentina and ongoing concerns about anthrax and terrorism attacks at home.

For the week, the

Dow Jones Industrial Average

fell 2.3%, the

S&P 500

shed 1.6% and the

Nasdaq Composite

slid 1.3%.

But the losses could have been worse given the week's harrowing economic news, including:

Tuesday's report that consumer confidence fell to its lowest level since 1994.

Wednesday's preliminary GDP report showing that the economy contracted 0.4% in the third quarter. The decline was less than expected but was still the first quarterly decline for the U.S. economy since 1993, and the biggest since the first quarter of 1991.

Thursday's report that the National Association of Purchasing Management's index of manufacturing activity fell to its lowest level since February 1991.

But after some steep losses Monday and Tuesday, equities proved willing and able to absorb and overcome the dismal economic reports. Friday's session proved an apt example as major averages finished mixed despite news the unemployment rate rose to 5.4% last month, its highest level since December 1996. Nonfarm payrolls fell by 415,000 in October, the biggest monthly drop since May 1980.

Many investors expressed shock and some confusion that stocks were able to rise late in the week in the face of such data. To cynics, investors were putting a wildly bullish spin on the economic news by declaring (again) that the data were so bad the worst must be behind the market.

But there was a fundamental rationale for the gains: The Treasury Department's midweek decision to eliminate future auctions of the 30-year bond.

Bond prices retreated Friday, but the overall decline in long-term yields is expected to spark economic activity. By compelling businesses to borrow (and then spend) and homeowners to refinance (and then spend the proceeds) the Treasury Department is attempting to do what multiple

Federal Reserve

rate cuts have so far failed to accomplish.

The impetus that low or 0% interest rates can provide to consumers was evident in a record level of auto sales in October. Equity investors clearly hope the decline in long-term interest rates can spur further economic activity.

Additionally, some investors determined that lower bond yields make equities relatively more attractive, as discussed

Thursday.

Among those investors is Don Hays of Hays Advisory Group in Nashville, Tenn., who issued a missive Friday morning entitled "Bonds Tip Valuation Back into Bullish Territory."

Heading into Friday's session, he estimated the S&P 500 was 15% undervalued when comparing the earnings yield of the S&P 500 -- earnings divided by price -- with the yield on the 10-year Treasury.

Of course, Hays has been bullish for some time now, and increasingly so in recent weeks. Cynics believe earning estimates used in such valuation models are way too high, thus making them worthless -- or, at least, a hollow basis for optimism.

But the point is that, for the time being, the bulls had a "fundamental" hook on which to hang their hats. Given investors' predilection (still) to be bullish, it didn't take much more that that to inspire buying. Speculation about the Justice Department's settlement with

Microsoft

(MSFT) - Get Report

, confirmed on Friday, and some positive comments from

Sun Microsystems

(SUNW) - Get Report

and

Micron

(MU) - Get Report

certainly also fueled buyers' desire.

Doubts About It

But as might be expected, many market watchers speculate there will not be much long-term stimuli from the 30-year's demise. In addition to the aforementioned skepticism about earning estimates, many simply doubt that long-term rates will stay down.

"I don't want to say none of it is fundamental because the

economic news this week is clearly friendly to longer bonds

but the rally in bonds appears more technical than anything else," said Thomas McManus, equity portfolio strategist at Banc of America Securities.

Indeed, after approaching 4.20% intraday Thursday, the yield on the 10-year Treasury ended the week at 4.35%.

Any "scarcity value" that pushes down long-dated bond yields will prove temporary, McManus believes. That's because "doing away with the 30-year opens a window of opportunity for government-sponsored entities and corporations to move in a much bigger way because there are clearly buyers" of bonds with long-dated maturities, he said.

If a shortage of long-duration assets does develop, McManus believes stocks in "defensive sectors" with "bondlike characteristics" could benefit. These characteristics include "steady growers" in which an investor can presume a long-term durability of a coupon payment in the form of a dividend or potential dividend. Companies with strong/dominant market positions, with high barriers to entry either through patents, a unique distribution system and/or the highest quality fit the bill.

Separately, Goldman Sachs' economics group suggested in a note on Friday that "the Treasury's decision to suspend all further 30-year borrowing is unlikely to have a major lasting impact on private economic or financing behaviors."

Goldman lowered its GDP forecasts "despite our recognition that fiscal policy is shifting sharply toward stimulus." The firm now expects GDP to contract by 3.5% in the fourth quarter of 2001 and 1% in the first quarter of 2002 vs. previous estimates of a 2.5% drop and a rise of 0.5%, respectively.

Of course, some degree of skepticism is considered beneficial to equities by many observers. Still, the onus is on the bulls to demonstrate the late-week recovery was more than just wishful thinking and that the worst news really is behind the market.