What a Week: It's All Good

Major averages open 2006 with big gains as traders choose to accentuate the positive.
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Don't worry 'bout a thing 'cause every little thing is gonna be alright.
-- Bob Marley

Refraining from worrying may be good for your state of mind, but it doesn't do much for the stock market. Contrarian investors point out that the best time to buy is often after periods of nervous, panicked selling, when anxiety and fear have become palpable.

This week -- which ended with all three major indices at new four-and-a-half-year highs -- was definitely not one of those periods.

With rosy glasses on, traders took friendly signals from

Federal Reserve

and ran with them. For the week, the

Dow Jones Industrial Average

rose 2.3%, the

S&P 500

gained 3% and the

Nasdaq Composite

advanced 4.5%.

It's not that the minutes of the Fed's Dec. 13 meeting weren't positive. The central bank again signaled that after 13 successive rate hikes over 18 months, monetary policy is near neutral. It also said that the number of additional rate hikes "probably would not be large."

But given that investors already pretty much knew the refrain since mid-December, the market's reaction speaks volume about the current bullish state of mind.

The minutes led to a big rally on Tuesday, as the Dow rose 129 points for the first trading session of 2006. Optimism continued pretty much all the way through Friday, when traders found little reason to fret about a lackluster gain in December payrolls.

The Dow added 77.16 points, or 0.71%, to 10,959.31 Friday while the S&P advanced 11.97 points, or 0.94%, to 1285.45. The Nasdaq rose 28.75, or 1.26%, to 2305.62.

In addition to a sense the jobs report would keep the Fed at bay, the market was also buoyed by strong December sales at electronics retailer

Best Buy

(BBY) - Get Report

. Goldman Sachs helped tech shares, boosting its price target on

Google

(GOOG) - Get Report

to $500 and on

Yahoo!

(YHOO)

to $50.

Friday's advance secured weekly gains, which was good news for those who believe that the first week of January means good things for stocks that month and also the year.

But for others, such as Chris Johnson, strategist at Schaeffer's Investment Research, the market's bullishness this week was just another example of how complacent investors have become with risks.

In addition, the jobs report was arguably strong enough to fuel inflation concerns with at least some members of the Fed, as reported

here. The 10-year Treasury did react to that possibility, falling 7/32 to yield 4.38%, up from 4.35% late Thursday.

The benchmark note did end the week virtually unchanged, however, amid further signs that the housing market is slowing. On Thursday, the National Association of Realtors said pending home sales dropped 2.5% in November, the third monthly decline in a row.

While it might be too soon to start noticing the pinch that consumers may feel from shrinking home equities, it wasn't comforting that Thursday also had

Wal-Mart

(WMT) - Get Report

warning that fourth-quarter earnings would be at the lower end of previous guidance.

The Price of Risk

It's not that every cause for concern has merit but it's the job of markets to put a price on risks, no matter how little the chance that such risk will turn into reality.

As discussed

here, current bullishness is being fed by expectations that the economy will remain strong enough to push profits higher -- but soft enough to take the Fed out of the equation. In other words, the market is again betting on the Goldilocks economy.

"Some would do well to remember that Goldilocks is a fairy tale," says Jeffrey Saut, market strategist at Raymond James. After riding the wave of the market's rally in November, he's remained in a "defensive posture," waiting for a pullback that has not yet materialized.

Still, he notes that while the market may have advanced this week, the dollar

fell sharply to start 2006.

The greenback was supported last year by the predictability of the Fed's "measured" tightening. Now that this predictability is gone, investing in dollar-dominated assets may not be such a safe bet anymore.

Concern about the greenback may help explain why flows into equity mutual funds turned negative in the week ended Jan. 4. According to TrimTabs Investment Research, funds that invest primarily in U.S. stocks had outflows of $1.9 billion, compared with inflows of $1.2 billion the prior week. International equity funds, meanwhile, had inflows of $1.3 billion, even if that was down from $1.6 billion the prior week.

On that note, with so much optimism about the Fed and the focus on Friday's jobs report, little attention was paid to Hu Xiaolian, the director of the Chinese Administration of Foreign Exchange, who said Friday that the agency will "actively explore ways of investing in foreign exchange more efficiently."

This all but confirmed previous statements from Chinese officials who've made it clear that China, which holds $760 billion of dollar reserves, will seek to diversify its assets. Others, such as Russia and South Korea, have also made similar calls.

In bond pits, worrying is more the norm. The news from China did put some pressure on bond prices Thursday, as did the jobs report on Friday. But the 10-year's yield of 4.39% Friday was little changed on the week.

With the Fed widely expected to raise the fed funds rate to 4.50%, the price of short-term bonds has continued to go down and their yields to rise. The yield of a two-year note finished the week at 4.35%.

The yield curve, which plots the yields of short- to long-term bonds, had inverted several times in the last two weeks of 2005, signaling to some economists that an economic slowdown -- or worse -- is in the cards.

The spread between the yield of the two-year note and that of the 10-year widened somewhat this week, although it remained a relatively narrow 4 basis points.

This brings us back to pricing risks. According to the economics team at Goldman Sachs, the persistently low yield of a 10-year bond is not signaling economic weakness. Instead, they suggest, it all goes back to Fed policy.

By systematically hiking rates over the past 18 months, the Fed was "pursuing an activist monetary policy designed to keep inflation well behaved," the Goldman economists wrote in a research note. As a result, "real short-term rates now move much more than inflation."

That has kept inflation -- and risk -- premiums very low over the past few years. Now that the Fed has reinserted some degree of uncertainty into the equation, maybe Wall Street will again learn to price in risks. That should provide some scary moments, but also some good trading opportunities for contrarian thinkers.

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 appreciates your feedback;

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