The ongoing tug-of-war we’ve recently written about continued last week as the market weighed the benefits of better than expected earnings reports against the potential of higher interest rates. Traders sold following Alan Greenspan’s congressional testimony on Tuesday sending the Dow Jones Industrial Average down 133.35 points to its lowest close since late March. However, things turned around on Thursday as good news was finally good and the Dow added 143.93 points. The late week rally sent most of the major indexes back to positive ground for the year. In addition, the Dow, NASDAQ and S&P-500 crossed back above their 50 day moving averages. For the week, the Dow gained 21 points (0.20%) and closed at 10472.
Aided by Microsoft’s stronger than expected earnings report, the NASDAQ powered ahead to its largest weekly gain in over a month. For the week the NASDAQ gained 54 points (+2.71%) and closed at 2049.
To get an idea of the effect higher interest rates may have on the markets going forward let’s take a look at the last time the Fed significantly raised rates: 1994. Beginning in February, the fed funds rate was increased from 3% to 6% over a twelve month period. The yield on the 10 year government bond increased from 5.7% to 8%. How did the markets respond? The Dow Jones Industrial Average started the year at 3756 and closed the year at 3834, a net gain of +2.0%. Not the greatest year on record, but not a disaster, and it set the stage for the extended bull market run of the later 1990s.
THE COMPASS PORTFOLIOS
No changes to our portfolios last week. The flurry of adjustments made over the past several weeks has repositioned client portfolios to be less interest rate sensitive, but still sporting a prudently cautious investment posture. Being less interest rate sensitive means having less exposure to utility stocks, no significant fixed income exposure, and a somewhat neutral exposure to equities. The topsy-turvy market action of last Tuesday’s late collapse and Thursdays explosive burst higher has been made tolerable by our neutral investment posture. Until the trading range breaks or until the environment becomes more accommodative for equities, I believe our neutral posture is the best course of action. The goal at this point in time is to take calculated and prudent risks, to maintain a flexible asset allocation, and to objectively monitor the markets on a daily basis for any changes.
During last week’s appearance before Congress, Alan Greenspan observed that “threats of deflation…are no longer an issue,” nor does he see that inflationary pressures are building. That deflation is no longer a worry should not come as a surprise. On the other hand, Greenspan’s comments on inflation may puzzle anyone who has bought gas for the family car recently. Part of the disconnect for the Fed is the way that the consumer price index is calculated: the “core” CPI excludes food and energy costs because they are deemed too volatile. As a result, the 22% rise in the national average price of regular gasoline since the start of 2004 isn’t captured in the core CPI rate! Increases in the prices of everyday purchases like gas make some individuals believe that inflation is higher than the government indicates. Whatever the belief of most investors, it is clear that the economy is growing, and the pricing of many products and services is becoming firmer. This environment is likely to result in the Fed raising short-term rates from their 46-year low, perhaps as early as June. At the current time, the market is being pulled in two directions, with bears focusing on the prospect of higher interest rates and bulls concentrating on strong corporate earnings. Standard & Poor’s equity analysts believe that, when the current reporting period is over, the S&P 500 will have posted a 20% year-over-year increase in operating earnings for the first quarter of 2004. They see almost as large a gain in the second quarter. Whether this data is factored into stocks at this point is anyone’s guess. Although higher interest rates are not a plus for equities, S&P thinks that the strong earnings picture will support stocks as they expect a 9% market advance for the current year. Time will tell, of course.