The sector leadership is puzzling to most analysts because typically, rallies during weak economic conditions are from the defensive sectors. Pessimists would say this, combined with low volume, is proof that we are seeing a fools' rally. Optimists like Ed Yardeni while interviewed by the Wall Street Journal last week point out that the economy is growing slightly below the trend rate of 3.0%-3.5% and we are still in a favorable interest rate environment with strong earnings growth.
This means cyclicals are leading the rally because the economy is doing better than expected and is anticipating future growth. Mild inflation news also served to stoke bond prices, driving yields on the 10 year to a three month low of 4.84%. Fed Fund Futures supported the view and closed with a 16% probability that the Fed would raise rates next month.
This is a lot of information to process, so let me help you surmise a conclusion: the markets are usually right and presently they are telling us that we are heading for a mild slowdown with sustainable growth and rate cuts next year.
The fly in the ointment is housing. Here is a list of the latest statistics from last week: Housing Starts down 13% year over year (Census Bureau), Permits down 21% year over year (Census Bureau), Builder Optimism at 15 year low (NAHB), Supply of New Homes up 28% year over year (Census Bureau), Foreclosure Rate up 25% year over year (RealtyTrac).
Those are some startlingly bad statistics. With housing jobs accounting for roughly 10% of job growth in 2005 (Labor Dept) and refi accounting for over 1% of GDP growth in 2005 (Goldman Sachs), we are likely to see a rise in unemployment and a drop in GDP growth. Based on that information it would appear that housing is in a free fall and going to take the economy right along with it. The important caveat here is that any time it wants the Fed can lower rates which will likely reignite the refi and sustain housing employment.
The problem with this neatly painted picture is that it doesn’t account for unknowns. For instance, most recent Fed cycles have been punctuated with a catastrophic financial crisis near the inflection point in the cycle. This usually causes a dramatic market sell off that acts as the impetus for cutting rates. Being that it’s difficult to build a portfolio to sustain a crisis and that in most instances long-term investors have been rewarded by not being spooked out during these crises, perhaps the best thing to do is stock you medicine cabinet with Tums and try to make prudent investments with realistic expectations.