Updated from 5:03 p.m. EDT Ironically, with the whiff of the bubble wafting from OSI Pharmaceuticals ( OSIP) and Google, this week was a tough one for the bulls. Hurt by a shocking disappointment from Nortel ( NT), tech stocks led the market's retreat, with the Nasdaq Composite falling 6.2% for the week while the Dow Jones Industrial Average slid 2.3% and the S&P 500 lost 2.9%. But in a week in which the "hot money" got singed on several fronts, commodities (save oil) also got hit following comments from Chinese officials about cooling off their economy, and emerging market debt tumbled. Treasury prices weakened as well, with the yield on the benchmark 10-year note climbing above 4.50% for the first time since September. Underscoring the action was more evidence -- namely from the
first-quarter GDP report -- that the economy is growing and inflationary pressures building, meaning the end of the Federal Reserve's easy-money policy is nigh. That, in turn, is prompting money mavens to reassess their exposure. "What you're seeing is the unwind of leveraged bets with a capital 'U'," said Mark Dow, co-manager of the ( MEDIX) MFS Emerging Markets Debt fund. "The fundamentals look great, but the rally was liquidity-driven, at least in the amplitude of the rise, and some of that has to be unwound. No one is talking anymore about a liquidity-driven market." Dow described a scenario in which money managers were able to borrow at the 1% fed funds rate (or slightly higher) and then buy emerging-market debt paper yielding 10%. "Now, we're closer to the inflection point of Fed tightening and there's an unwinding of risk," he said. "Guys are saying 'We're in a new environment, the wind is in our faces. We have to get back to flat posture and see how we're going to make money in the new environment.' That's what we're seeing." Dow was speaking specifically about the emerging market-debt arena, where Brazilian bonds were rattled this week, and, to a lesser extent, high-yield debt. But, rest assured, the same scenario is playing out in other asset classes, equities definitely included. (It's worth recalling that emerging markets often presage action in stocks and Treasuries, as was the case in 1994 and 1997-98.)
"We've been saying to clients, 'it's time to up the quality/liquidity trade'," Dow said. "We'll give up 50 basis points of yield to avoid the risk of losing 10 points in a day when there's political turbulence in Ecuador." Where Dow's fund has gravitated toward more-stable emerging market names such as Mexico in recent months, many of his equity peers are now doing the same; i.e., moving from high-beta tech stocks into less-sexy but safer plays such as Johnson & Johnson ( JNJ). This is a crucial concept because many readers have expressed amazement that financial markets could be rattled by the threat of higher interest rates, which have hovered near 40-plus year lows and "everyone" knows they're going up. Yes, "everyone" knows they're going up, but prior to the April 2 March employment report, many market participants believed the central bank would hold off until after the election or until early 2005. In the wake of that strong jobs report, most timetables have been accelerated, prompting the aforementioned unwinding process. Certainly, geopolitical concerns matter, but the cost of capital is arguably the single-most important factor on Wall Street. All this is an attempt to explain the market's struggles in April despite mostly strong economic data and solid earnings results; for the month, the Dow fell 1.3%, the S&P lost 1.7% and the Nasdaq shed 3.7% while the yield on the 10-year Treasury rose 68 basis points. Due to similar factors -- concerns about higher rates curtailing the economy and the end of the cheap-money bonanza -- copper and gold prices stumbled in April, with gold sliding 8.4% and copper down 14.6%.
"Investors have been left to wonder why it is that stocks are no longer advancing in the face of all this good news" on the economic and earnings front, Bear Stearns strategist Francois Trahan wrote this week. "The message from these indicators is clear: The best of times are behind us for stock prices, and more measured returns should be expected going forward." That may be the outlook for the intermediate term, but it's certainly possible riskier bets could soon rebound after this week's washout, perhaps in concert with Tuesday's FOMC meeting. "Maybe short term we're done unwinding," Dow said. "But until high-yield
debt converges down with emerging markets, it's hard to imagine we're done flushing the risk out of the system." Again, I believe, what's applicable for high-yield debt is germane to equities -- very germane. Finally, I'll be back on John Batchelor's ABC Radio Network show to discuss these and related issues Friday night/Saturday morning, around 9:30 p.m. PST/12:30 a.m. EST. Check the ABC Radio Web site for local listings or Webcast options.