For the first half of 2013, the Dow rose 13.8%, NASDAQ +12.7%, and the S&P 500 +12.6%, marking the best first half since 1999, the last of five consecutive years of double-digit annual gains. Now, with U.S. Treasury bond yields shooting up so rapidly, it appears we're finally seeing the start of a rotation from bond funds into equity funds, reminding me of a similar situation in 1994 when bond yields rose by 245 basis points, launching the most explosive phase of the 1990s stock bull market. Could it happen again?
Beware the "Bond Bombshell" of 2013
While traveling last week, I kept hearing stock brokers ask: "What are my fixed income clients going to say when they receive their June monthly statements?" Due to the sudden surge in Treasury yields in the past two months, bond investors have had a truly horrific few weeks watching their principal erode due to 10-year Treasury bond yield rising from 1.66% on May 1 to an intraday peak of 2.67% last week, before settling back to 2.52%.
In response, PIMCO's Bill Gross and five Fed Presidents were out and about last week telling investors that Fed Chairman Ben Bernanke's recent comments were "misinterpreted," and that bond investors have grossly "overreacted." For instance, New York Fed President William Dudley said last week that any expectations of imminent rate hikes are "quite out of sync" with the FOMC's official statements and the expectations of most FOMC participants. Still, bond investors withdrew $23.7 billion from taxable bond funds in the past four weeks. Additionally, foreign central banks sold $32.4 billion in Treasury debt last week, the largest weekly redemption ever and the third net weekly withdrawal in the past four weeks.
Bond yields have settled a bit in recent days, but the damage has been done. Fixed income investors seem to be realizing that bonds are not an oasis of safety when their principal erodes so rapidly. The last time I can remember seeing such a sudden spike in bond yields was 1994, when 10-year Treasury rates rose from 5.6% in January to over 8% in November. That sparked an impressive stock market rally in 1995.
The strong recovery in stocks since last Tuesday suggests that this bull market remains healthy and resilient. The stock market could become the new oasis for conservative investors, just like it did back in 1995. So far, the market gains of 2013 rival the start of the big market surge in 1995. Now, as then, the bull market was already 4+ years old - starting in late 1990 - but the biggest gains were yet to come.
Stat of the Week: First Quarter GDP Revised Down to +1.8%
Ironically, the market rose strongly after we learned that the first-quarter GDP was revised from an annual rate of 2.4% down to only +1.8%. Since slow growth implies that the Fed will likely continue its round of quantitative easing (QE), the market greeted this otherwise-dismal news with a sigh of relief. Still this GDP revision was a big surprise since the consensus estimate was for "no change," i.e., 2.4% growth.
The Commerce Department reported that the primary reason for the big downward revision was that the service sector only grew at a 1.7% annual pace, down from its preliminary estimate of 3.1%. Business investment was also revised down to an 8.3% decline, from a preliminary estimate of a 3.5% decline.
A growing trade deficit also weighed down GDP, since U.S. exports actually declined 1.1% in the first quarter instead of rising 0.8% as in the Commerce Department's preliminary estimate. Imports fell 0.4%, well below the Commerce Department's preliminary estimate of a 1.9% rise. Clearly, a strong U.S. dollar and slower global economic growth sharply reduced American exports and imports in the first quarter.
Tuesday's Positive Economic Statistics Rallied the Stock Market
Even though the first quarter grew slower than expected, the second quarter looks stronger. The latest stock market rally began last Tuesday, in response to a string of positive reports about the second quarter:
(1) First, the Commerce Department said durable goods orders rose 3.6% in May for the second straight 3.6% monthly gain, due largely to a 51% surge in orders for new passenger jets. Even without defense and aircraft orders, however, May business investment still rose by a respectable 1.1%, the third straight monthly gain. Excluding all transportation orders, May durable goods orders rose by 0.7%.
(2) The second factor that sparked a rally on Tuesday was the improving housing sector. Case-Shiller reported that its 20-city index rose 2.5% in April as 19 of 20 cities reported rising prices. Compared with a year ago, the S&P/Case-Shiller index is up 12.1% and is now growing at its fastest pace in seven years.
The Commerce Department also reported that new home sales rose 2.1% in May, reaching an annual pace of 476,000. In addition, the supply of new homes remains tight, at only a 4.1-month supply.
(3) Another factor that sparked Tuesday's rally was that the Conference Board reported that consumer confidence surged to a five-month high of 81.4 in June, up from 74.3 in May. The present situation index rose to 69.2, up from 64.8 in May, while the expectations index surged to 89.5, up from 80.6 in May. The only negative number came from those saying that jobs were "hard to get." That figure rose to 36.9%, up slightly from 36.4% in May. Since the Fed has stated it will continue "QE" until the jobless rate falls to 7%, this is good news for stocks, implying that the Fed will likely keep its money pump flowing.
More good news on the consumer front came out on Thursday when the Commerce Department reported that personal income rose 0.5% in May and consumer spending rose 0.3%. As a result, the savings rate rose from 3% to 3.2%. Since consumer spending accounts for approximately 70% of GDP growth, rising personal income and consumer spending growth in May bode well for better second-quarter GDP growth.
The Wall Street Journal's latest survey of leading economists shows a median expectation of 2.3% GDP growth this year, expanding to 2.8% in 2014. The Fed is much more optimistic, expecting between 2.9% and 3.4% GDP growth this year and 3.0% to 3.5% growth in 2014. This glaring discrepancy in forecasts tells us why there is so much confusion on Wall Street, but I side with the private economists. As a result, I expect the Fed to continue its $85 billion per month in monetary easing well into 2014 and maybe 2015.
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