Tuesday's robust advance may prove to be the "last gasp" of the rally or perhaps the beginning of the "blow-off phase" some predicted as the advance from the mid-March lows gathered momentum. But wild action in (particularly) biotech and Internet stocks such as Celgene ( CELG) and Amazon.com ( AMZN) aside, there's arguably a method to the madness. Beyond near-term developments, which were largely positive, there are some underlying supports to the bullishness, as discussed later in this piece. We begin, however, with the headlines. Lower taxes, prospects for peace in the Middle East, rising consumer confidence and ongoing strength in housing were among the catalysts cited for Tuesday's rally, which saw the Dow Jones Industrial Average rise 2.1% to 8781.35, the S&P 500 gain 2% to 951.48 and the Nasdaq Composite jump 3.1% to 1556.49. Tuesday's closes are the averages' highest yet since the March lows. The Dow and S&P eclipsed respective intraday highs hit on May 16 and the Comp on May 15. Technically speaking, that's all "good" and the S&P is now 3 points away from its Dec. 2 intraday high of 954.32, a closely watched resistance point.
should not underestimate the significance of this tax reform," opined Kent Engelke, capital markets strategist at Anderson & Strudwick. "This lowering of marginal tax rates on personal income and capital encourages entrepreneurial activity, which will increase economic growth and hence stock prices, for the intermediate future." Educated people will argue the merits of the package. Notably, the euro surged to an all-time high of $1.1932 intraday Tuesday before retreating to around $1.1832 in late New York trading. The euro's latest rally partly reflected concerns about further dollar weakness due to America's rising deficits, which last week's congressional passage of a $350 billion tax cut will exacerbate.
But Engelke effectively summed up Wall Street's upbeat assessment, declaring: "We believe the larger initial deficit will be repaid by the increased tax revenues generated by greater economic activity." (Again, educated folks can, and do, disagree and only time will tell who's right.) Similarly, Wall Street viewed the Conference Board's consumer confidence report through bullish lenses. Although the headline number rose to a six-month high of 83.8 in May, it was below consensus expectations and the "present situation" index fell to 67.9 from 75.2. Additionally, those reporting jobs "hard to get" rose to 32.6%, the highest level since January 1994. (The April housing data, conversely, was more uniformly positive -- assuming there's no "housing bubble," of course -- as both existing- and new-home sales bested expectations.) "This is looking increasingly like 1991, when consumer confidence popped after the war only to deteriorate over the course of the year as jobs remained scarce," commented David Rosenberg, chief North American economist at Merrill Lynch. "Who says history doesn't repeat itself?" While not an exact repeat of the 1991 Madrid Conference, progress was made over the Memorial Day weekend on the so-called road map between the Palestinians and Israelis, a bullish development for humanity and financial markets. Just as President Bush used his postwar popularity to push tax relief through a divided Congress, so too is his personal involvement crucial to advancing the Mideast peace talks. The Tel Aviv stock market surged Monday and rose another 1.25% overnight Tuesday on hopes the Bush administration can broker a deal that will satisfy Palestinian desires for statehood and assuage Israeli's fears about security. No doubt part of Tuesday's rally in U.S. equities is attributable to similar hopes here.
Arguably this is bullish because many fretted the bond market's recent rally (and falling yields) suggested the equity market was wrong in betting on an economic recovery. If nothing else, weakness in Treasuries could be a sign the much-ballyhooed asset-allocation swap, particularly by pension funds, is starting. Should strength in stocks and weakness in Treasuries become a trend, it also will likely curtail mutual fund inflows into bond funds. Equity funds are the most likely beneficiary. The issue of stocks' relative attractiveness vs. Treasuries recalls recent conversations I've reported on previously, but bear repeating. At Tuesday's close, the earnings yield of the S&P 500 -- the inverse of price-to-earnings -- is 5.0 based on actual 2002 earnings of $47.94. The earnings yield is 5.5 based on Thomson First Call consensus estimates for 2003. Those estimates may prove overly optimistic, but the point is the S&P's earnings yield is higher than that of both the 10-year Treasury note (3.41%) and 30-year bond (4.38%.) As mentioned
here last week, that suggests equities, overall, aren't as wildly overvalued as many observers contend. Ken Fisher of Fisher Investments noted as much in Forbes, suggesting stocks "aren't expensive" based on the earnings yield. Going back to the prior week , Brett Gallagher of Julius Baer Asset Management discussed how the recent fall in interest rates was making equities more attractive based on a dividend discount model. (Interest rates are a key component in determining the present value of future dividends expected to be paid by a given company, which is what the model is designed to assess.) Notably, Gallagher is far from bullish. He was grudgingly buying shares to reflect what may sound arcane to some readers but is a standard part of the fundamental "tool chest" used by many institutional investors.
Similarly, there's been a lot of hand-wringing in some circles about recent gains by many small-cap stocks. Optimists contend the sometimes-startling percentage gains reflect that shares of many firms were trading below cash levels in October. Because these firms avoided bankruptcy and the economy is (presumably) recovering, the gains are justifiable and logical.
Friday , I wrote how the "animal spirits are alive on Wall Street." While I don't recommend tossing aside reason and blindly joining the euphoria, not all animals are dumb beasts.