BigTrends

For the month of May retail sales came in lower than expected, and that may be a concern going forward.  The economy was already considered to be on difficult footing before this report, and while the market looks forward this was probably 'assumed' back in February (remember that dip in the market?).

We may see this be an important figure for future GDP numbers, specifically 3Q.  I've seen some numbers thrown around with -2% GDP in that quarter, which will cause shockwaves.  Is the market discounting it already?  Hard to see that right now, but second quarter earnings will be key. 

I recently received this question about the BigTrends 2010 Outlook that I would like to share along with the answer:

"Bob, I am trying to understand the corelation of bond rates and the effect that has on equities. I am hoping you can put this in laymans terms, please. Thank You xxxxxxxxx"

Thanks for your question.  I'll do the best I can to make this seem simple. 

There are different ways bonds and equities interact with each other in markets.  The most basic tenet is liquidity or money flow.  Let's pretend for a minute that there is a limited amount of capital in the system (I say pretend because the printing presses run hard everyday).  The search for yield is constant, but also must be balanced by risk tolerance.  An investor would like a given amount of return for a far amount of risk taken. 

So, where should that capital be deployed?  In most cases it's a choice, or even an allocation to either/or.  Since equities have a higher beta (risk) than bonds, you have the following:  If you desire less risk, you put more into bonds, less into equities.  More risk, vice versa.  Capital flows back and forth.  A strong bond market though, with money flowing into it is good for stocks, too.  How?  borrowing costs, costs of capital are lower which means more to the bottom line.  

I spoke recently about the yield curve and its importance.  The desire for an upward sloping yield curve is attractive to equities as it portrays growth (good productivity means it's not inflationary)...too steep and it's probably inflationary.  We have not had consistently good growth for a couple of years.  The Fed wants to see a steeper curve before it raises rates, even more they want to see good GDP numbers before they act.  What does an upward sloping yield curve represent?  If you lend your $$$ out longer you should be compensated better, with a higher rate. 

How do you shift the curve?  It needs to be whipped from the bottom (fed funds rates) or the top (10 year or longer).  Draw a yield curve on a line chart and you'll see it (upward sloping, left to right).  An inverted curve is not positive and is recessionary.  Further, we also watch spreads between riskier bonds (corporates) and treasuries to make sure there is no disconnect of historical risk.   So, the answer is low rates are good for stocks, but falling yields will take away from equities due to risk aversion.

The last (maybe) version of the 3Q GDP is out and it appears to be a bit less than expected, or that reported last time around.

So, what to make of it?  If you're in the equity/risk market camp you can celebrate, as this is another data point that pushes rate hikes out further into the future.  This keeps the Fed on the sidelines longer as they are clearly concerned about growth. 

There's alot of confusion about what's happening with the dollar, and most notably interest rates.  Make no mistake, the dollar is on the rise (mend?), and rates are starting to shoot up.  Treasury yields are at levels not seen in four months There is a very positive relationship there, too.  We've seen historically that rates rise when the economy starts to improve and the dollar moves with them in unison.

Note back in the late nineties, the true period of 'excess' in markets, and with valuations shooting into the stratosphere, rates were on fire, the dollar was strong (of course, much less deficit than today) as the Fed prepared to prick the bubble.  But what of stocks?  It was the best time for growth, and as wild as it may have been business was booming.  GDP growth was strong as was productivity.

We saw a similar pattern arise in 2004, and with it strong equity growth.  I suspect we're in for the same scenario, as the Fed will wait to see strong growth and potential inflation before making a move on rates.   That could come soon, or later.  The Fed Funds expects the first rate hike could come in September 2010, but that is clearly a longshot.

I suspect we'll see some sizeable market gains over the next several weeks.