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The stock market has derived a tremendous amount of support from a much improved interest rate environment. Over the past two months, the 10-year Treasury yield has dropped ½ percentage point from 5.25% to 4.75%. With respect to Fed policy, over this same time period, the markets have gone from expecting an additional Fed rate hike in 2006 to now expecting no further increases in 2006 and two cuts in the federal funds rate in 2007.

A significantly positive shift in interest rate expectations has already occurred, and we do not expect any further improvement in monetary conditions (either Fed policy or market interest rates) in the near term. With commodity prices in retreat, and with inflation data having improved slightly over the past six weeks, the Fed’s decision to pause in August now appears well-timed.

The markets fully expect the Fed to remain on the sidelines for the second consecutive month when the FOMC meets this week on September 20. Additionally, we expect the Fed to retain its tightening bias, which will prevent the stock market from discounting any further good news on the monetary front in the near term.

The bond market, in our view, has gotten ahead of itself and is vulnerable to correction of a significant portion of its recent gains.

With the S&P 500 and the Dow Jones Industrial Average flirting with new bull market highs, and lagging indexes such as the Russell 2000 having recovered and broken above their downtrends, the technical health of the stock market is clearly much improved. While the market is looking somewhat overbought in the near term, the advance since early August has been a gradual, methodical move higher, and it is encouraging that prices have remained firm as trading volumes have returned to normal levels in September.

The obvious test now for the markets is to be able to move to new 2006 highs, which appears likely in the weeks ahead. Sentiment is not so bullish yet as to stop this rally in its tracks, and valuations have room to expand given the recent decline in bond yields and with the Fed on hold. Indeed, market interest rates likely can back up some without immediately undermining the stock market. Still, we don’t have conviction yet about a sizable or lasting move higher in stocks, so we are hesitant to position our portfolios with a more aggressive stance. We are comfortable for the time being maintaining a healthy reserve of liquidity in our portfolios, particularly in light of the 5% yield available from cash.

Despite some constructive elements that appear to be falling into place – supportive interest rates, relief on energy prices, and a moderate economic slowdown - our concerns about the economic backdrop have not gone away. The outlook for consumer spending continues to look poor, though it is impossible to pinpoint when and how far consumers will retrench. Although now well-publicized (which in and of itself relieves some of our anxieties), the housing story is likely still in the early stages of unfolding. There are excesses that still need to be unwound in the areas of mortgage debt and real estate valuations.

Moreover, many of the new jobs created in the current cycle have been either directly or indirectly tied to the housing boom. As housing continues to slow, the unemployment rate is likely to rise and put further pressure on consumer spending. In short, the strong action in the stock market and the corporate credit markets is signaling that the economy is fine, but we would like some additional confirmation.

For instance, we would like to see more of an improvement in the leading economic index from the Economic Cycle Research Institute. The growth rate in ECRI’s leading index has been edging up since mid-August, when it hit a three-year low, but ECRI is still forecasting a very muted growth environment, which seems out of alignment with the double digit profit growth expectations for the next two quarters.

DJIA vs. S&P 500 1-yr chart:

Source: Stock Market Health Improved, But Concerns Remain