THE MARKETS
The bulls went on a stampede last week as the majority of the averages took out major resistance areas and never looked back. The recent run up by the Dow has been confirmed by the broader indexes suggesting further gains down the road. However, the market is significantly overbought and will need to digest its gains before mounting another attack. The Dow Jones Industrial Average, which finished higher on all five trading days, gained 212 points (+2.4%) for the week and closed at 9062. The close over 9053 on June 6th triggered a Dow Theory buy signal suggesting that a long-term, sustained up side move is in the cards. The NASDAQ, fueled by the strength of the tech stocks, has posted gains for seven of the last nine trading days. For the week, the index gained 32 points (+2.0%) to finish at 1627.
Equity mutual fund inflows continue to be slow and steady. For the week ending June 4th, U.S. inflows were $1.5 billion compared to inflows of $2.8 billion the previous week.
Much of the market’s recent run is built on the belief that the economic environment will improve in the second half of the year, evidenced by improved corporate spending and a new round of hiring. Much of this hope is reflected in the markets at this time, and the data has to eventually support current valuations. Institutions are slowly beginning to revisit equities once again, leaving the door open for broader participation both by individual investors (who don’t wish to be left behind) and foreign investors (who abandoned the markets over the past two years).
THE COMPASS PORTFOLIOS
All indicators continue to prescribe “LONG” positions at the current time, as they have since the late March/early April time period. Readings also indicate “overbought conditions,” which means that the markets have come too far, too fast, and a mild round of profit taking should be expected. Normal consolidation would include activity that may retrace 3-5% of the recent run-up, but that would leave a solid base from which to attempt new highs. There now exists a significant gap between where positions were recently established and where they rest, creating the genuine likelihood of durable gains regardless of the sustainability of the rally.
THE ECONOMY
It remains unclear whether the recent strengthening of economic momentum should be attributed to the reduction of geopolitical uncertainty or the newly passed tax-law changes. Here are a few things to consider:
First, it seems as if war-related news has just left the front pages over the past few weeks — since President Bush’s infamous aircraft-carrier landing — and stock prices have only commenced a robust upward trend from then. Second, passage of the tax law may have displaced war news, giving a positive “confidence” effect beyond the impact of higher after-tax incomes. Finally, consumers and managers will need to see that economic momentum is building elsewhere before expressing true confidence in the recovery, and this effect could easily add several months’ delay to a solid and sustained postwar rebound.
Most confidence measures and surveys are already posting a recovery from the depressed levels that most likely reflected uncertainty ahead of the war. The Michigan consumer sentiment index fell from a seemingly respectable 86.7 reading in December, 2002, to a war trough of 77.6, before rebounding in April to 86, and in May to 92.1. The Conference Board index fell from a prewar reading of 84.9 in November, 2002, to a low of 61.4 in March, but then surged to 81 in April and hit 83.8 in May.
Both indexes are likely to rise further in June and July, given passage of tax-law changes and the probable start of a rebate program and lower withholding rates by midyear. Yet, such a run-up may ultimately prove as much a reflection of a postwar rebound as a response to changes in the tax laws.
A similar lift is documented in the various surveys by the Institute for Supply Management that measure activity in manufacturing and services and by the Philadelphia Fed survey. They showed highs around the turn of the year, then troughs for all of these measures in April, before beginning a comeback that, though hardly startling, is clear. And finally, falling prices of goods and services in April and May imply that inflation-adjusted sales are doing much better than suggested by the nominal retail-sales and factory-production figures, indicating that a postwar recovery may be more broad-based than generally appreciated.
