A wave of Republican victories and a 1/2-point interest rate cut on Wednesday drove the market higher for a fifth straight week. However, the rally ran out of steam late in the week as renewed concerns over a war with Iraq intensified. Since the October 10th lows the Dow Jones Industrial Average, S&P 500 and NASDAQ all have rallied in excess of 20%. For the week, the Dow gained 19 points (+0.2%) and closed at 8534. The NASDAQ lost 1 point (-0.1%) and settled at 1359.
A larger-than-expected interest rate cut of 50 basis points by the Federal Open Market Committee earlier in the week still has investors somewhat uneasy. Economists are unclear as to what the move says about the Fed’s confidence in economic recovery and what it means for the possibility of another rate cut. The Fed has now lowered rates 12 times since the economy began to stall in 2000, bringing the overnight rate to a record low of 1.25%.
Investors will likely continue to mull the passage by the U.N. Security Council on the Bush Administration’s Iraq resolution. The revised proposal has a seven-day deadline for Iraq to accept the proposal. In 30 days, Iraq must declare the status of its weapons inventory. Any false statements or omissions would constitute a “further material breach” by Iraq of U.N. obligations.
THE COMPASS PORTFOLIOS
No changes to our models during the past week. In short, we are cautiously optimistic that the markets will continue a trend of slow, steady appreciation. The recent upgrades we have acted upon position our clients such that a continued market rally will produce positive results. Most portfolios sport an offensive posture with an overweighting on equities, and a declining position in bonds and money market assets. While still having an eye on managing investment risk, this posture is more assertive than we have been in the last six months, a prudent step given the severity of declines that have been avoided.
We are continuing to underweight fixed income securities such as bonds, preferred stock, and money market instruments given the diminishing yields and the likelihood of higher rates going forward. Many clients will notice that we are using the Dow Jones Utility iShare as a bond substitute, given its high yield and its sharp fall over the past year. While a rising interest rate environment can be detrimental to bonds and bond funds, the inherent value of utility dividends is an attractive option at this point in time. We will continue to monitor this position on a daily basis, being mindful of the possibility of future weakness.
Granted, consumer confidence has fallen sharply and the economic pillars of autos and housing appear to have cooled. But there’s a risk the fundamentals will prove stronger than the Federal Reserve anticipates. After all, oil prices tumbled 18% in October, Gross Domestic Product growth is averaging 3% so far in 2002, and the NASDAQ composite index has rebounded nearly 30% from its October lows.
In its accompanying statement, the Fed wrote that “greater uncertainty, in part attributable to heightened geopolitical risks, is currently inhibiting spending, production, and employment.” Previously, the Fed used the phrase “considerable uncertainty” in the context of an expected pickup in production and employment. While the statement was far more subtle than the actual action taken, the policy suggests that the Fed hopes a half-point cut was enough of a surprise to energize consumer, business, and investor confidence.