THE MARKETS
Fears over rising interest rates, a significant uptick in inflation and continuing instability in Iraq continue to create a hostile market environment. Mix in the high price of crude oil and that was enough to send the Dow Jones Industrial Average and the S&P-500 down for the week, retesting their respective 200-day moving averages. For the week, the Dow lost 105 points (-1.04%) and closed at 10012.
The NASDAQ stabilized after Monday’s sell-off, benefiting from an oversold condition. Frustration was still evident though as strong earnings reports from Cisco Systems and Dell Computers failed to support their respective stock prices. Prior to Friday’s selloff, the NASDAQ had been trading slightly below its 200-day moving average. For the week, the NASDAQ lost 13 points (-.68%) and closed at 1904.
THE COMPASS PORTFOLIOS
The defensive measures we have taken over the past six weeks are providing significant stability in the current hostile environment. After further reducing already meager equity exposure, our portfolios now typically contain 10% equities, 0% fixed income, 90% cash. This allocation is extreme, and reflects a market environment that has steadily progressed from neutral to outright bearish. Given the current level of support for equities by the institutions, this allocation is prudent, and should serve us well if the market weakness continues. We’ve also been able to entirely avoid market sectors that have seen significant weakness this quarter, including Real Estate (-16.26%) and Gold (-23.45%).
Conventional wisdom suggests that bonds and stocks always move in opposite directions. Bonds are typically strong during periods of stock market weakness (flight to safety) and bonds are typically weak when the stock market is strong (better opportunities in stocks). So, why the absence of fixed income if the stock markets are weak? In short, the current environment is anything but typical. As interest rates have continued to climb, bonds have become less valuable, for good reason. As an investor, if I can choose today to buy a bond that is yielding 4.00% or wait six months and buy the same bond yielding 5.00%, I’d rather wait. The bond market is clearly reflecting the belief that rates are moving higher in the future, and that bond purchases should be delayed. Why the simultaneous weakness in stocks? Higher interest rates make it more difficult for companies to expand, they create more competition for stock dividends, and the extent to which yields will rise is still unclear. It truly is the perfect storm, an environment in which “cash is king,” at least for the time being.
THE ECONOMY
Demand for U.S. home loan refinancings plummeted last week amid a rise in mortgage rates, but applications for loans to buy homes rose, an industry trade group said on Wednesday. The Mortgage Bankers Association said on Wednesday its measure of demand for mortgage refinancings, the refinancing index, fell 13.2 percent to 2,184.6 in the week ended May 7. That drop in demand for loan refinancings came as average interest rates on 30-year mortgages rose 22 basis points to 6.32 percent, the highest level of the year. Mortgages refinancings have helped fuel consumer spending over the past several years as homeowners “cash out” equity in their homes to fund other purchases or to finance home remodeling projects. Any slowdown in cash out activity could have a significant impact on future consumer spending.
In related news, U.S. retail sales cooled in April, a government report said Thursday, dragged lower by declines at auto dealers and clothing stores. The Commerce Department said retail sales slid a greater-than-expected 0.5 percent in April to a seasonally adjusted $331.84 billion. Sales excluding autos were off by a smaller 0.1 percent. Economists had been expecting the slowdown, given the big jump in March sales. March retail purchases were revised to a 2.0 percent gain in the report, up from the previously reported 1.8 percent rise. Wall Street economists had expected April overall sales and sales excluding autos to drop by 0.2 percent after March’s hefty advance.
The Federal Reserve will raise a key short-term interest rate to 2.5 percent 12 months from now and 3.5 percent by the end of next year, the Wall Street Journal reported Thursday. The daily paper reported that 43 of 55 economists surveyed said they expect the central bank to raise its target for the federal funds rate, an overnight bank lending rate, starting in June, up sharply from a month ago when most economists surveyed said the Fed would raise rates in September. Those surveyed predicted that the fed-funds rate would rise to 1.25 percent in June and hit 1.75 percent by December, 2.5 percent a year from now and 3.5 percent by December 2005.
