No Agreement on Economy, Yet the Market Marches Higher

by: Caleb Sevian

If you feel confused about which direction the economy is headed, don’t feel alone -- the top Wall Street firms can’t agree either.

Currently Goldman Sachs, Citigroup, and Merrill Lynch think the Fed will be cutting rates in 2007, whereas Morgan Stanley, JP Morgan, and Bear Stearns think the Fed will leave rates steady or have to raise them in 2007. If that’s not bad enough last week the Fed itself showed growing signs of uncertainty when two more Fed Governors (Kohn & Plosser) suggested that the Fed should not be considering easing but perhaps raising rates. That brings the total now to three out of twelve Fed Governors in the hawkish camp, not that the market is paying any attention.

Meanwhile the stock market and the bond market seem at odds as well. Bond yields are falling and the yield curve is inverted, that means the bond vigilantes are mostly likely thinking economic slowdown, but the Dow Jones Industrial Average just eclipsed its all time high and earnings are set to grow nearly 14% this quarter according to Thompson Financial with unemployment at 4.6%.

With both the hard landing and soft land ends of the spectrum well represented it seems safer to hide on the softer side as Mr. Bernanke did last week in his speech at the Washington Economic Club where he suggested that housing will indeed slow the economy and inflation will be tamed. Bloomberg was kind enough to poll 74 economists for us whose consensus opinion was that rates will be cut towards the end of Q1 2007 lending credence to Mr. Bernanke’s comments.

Historically that would mean over half of our correction for the economic slowdown that usually ensues as are result of hawkish Fed policy should occur by then. But as I pointed out in last week’s piece, with P/E’s trading at a ten year low and corporate balance sheets holding in excess of 770 billion in cash, a record level, the sell off from here is likely to be muted.

The biggest risks facing the markets right now have to do with earnings and oil prices. Next week kicks off earnings announcement season. We are expecting the 13th straight quarter of double digit corporate earnings growth, a feat only achieved once before. With lower oil prices and falling yields corporations will have something positive to speak about, but if an economic slowdown is in the wings, discussing how this slowdown will affect future growth prospects will be the focus of most investors. Clearly analysts are worried about this as well given that upgrades have been unusually low going into earnings season.

Last week OPEC signaled they intend to cut production by one million barrels a day. This is likely to curtail the free fall of crude and place it in a trading range of $58-$64 a barrel. Since we are at the bottom of that range now the next likely move from here is up. This all seems to point to a mild head wind though out earnings season that is being offset by optimistic market psychology that seems to be over powering even the most ardent bears at the moment.