Stocks Have Bottomed, Credit Crisis Passing? Not Quite

The stock market continues to display its resilience. In spite of a further $2.68 rise in the price of crude oil last week to a record $118.84 (May contract) and bearish economic reports on housing and consumer confidence, stock indexes have held their recent gains, and today appear poised to exceed key resistance at the 1400 level on the S&P 500. Since mid-January, the S&P 500 has fluctuated within a range of 1260 - 1400. A break above the 1400 would be technically significant and likely encourage follow-through buying and short-covering, setting up a near-term price objective in the 1425-1450 range, which is where the next major area of resistance comes in.

Apart from the bullish action of stock prices over the past six weeks, there have been obvious signs of healing in the credit markets since the mid-March crisis point coinciding with the Bear Stearns debacle. Yield spreads on investment-grade corporate debt have tightened 50 basis points from the highs reached in the first quarter, and spreads on high-yield corporate debt have narrowed approximately 200 basis points.

The volume of bond issuance has jumped 25% in April compared with March. As risk-aversion has abated, money has been flowing out of Treasuries, which had been the beneficiaries of enormous flight-to-safety buying in the midst of the panic. At the height of the crisis, two-year Treasury yields plunged to under 1.5%; they are now at a three-month high of 2.42%. Similarly, 10-year Treasury yields reached a low of 3.3% in mid-March, and have subsequently jumped to 3.87%.

Given the market improvement in financial market conditions in recent weeks, we are hearing the increasingly prevalent assertion that stocks have bottomed and that the credit crisis is largely behind us. We are open-minded to this possibility, and will set our course as evidence develops, but at this juncture we believe it is quite premature to assume that a bottom is in place, and we are doubtful that a sustained upturn is underway.

Stocks were very oversold in mid-March when the Bear Stearns (BSC) news broke. Apart from short-lived relief rallies, stock prices had been falling since the start of the year. In addition, investor pessimism was at an extreme, due to the relentless flow of bad news about the financial and real estate markets in the first quarter. Accordingly, stocks were primed for a rebound, which is what we have seen and may continue to see for a while longer. Now that equity prices and credit markets have stabilized, investors and advisors have become impatient about keeping cash on the sidelines, especially when you are getting paid a negative real return on risk-free instruments (yields on risk-free money market funds and CDs have dropped 250 basis points in the past eight months).

Despite this pressure to "put money to work," we recommend staying neutral-to-cautious on stocks (rather than adopting a more bullish intermediate to long-term posture); treading lightly with higher-risk bonds; and keeping a healthy cash reserve. The recession is at an early stage; housing prices remain in a downward trend; and extended period of debt and consumer spending retrenchment quite possibly lies ahead.

In short, we have little conviction that the flow of negative surprises has ended. Despite negative real returns on cash, our view is that being liquid is not bad at all in this environment. Further, investors who felt over-exposed to stocks during the turbulence of the first quarter may wish to take advantage of this rally to lighten up.

In light of last week's $30 drop in the price of bullion, a comment about the gold market is in order. Gold has been under pressure in recent weeks from a combination of (1) rising stocks and a narrowing in credit spreads, both of which are reflective of a lull in risk aversion, and (2) rising Treasury yields, which has helped support a nascent rebound in the U.S. dollar. Last week, the dollar bounced following a story in the Wall Street Journal that this week's widely anticipated quarter-point cut in the fed funds rate (to 2%) may be the last.

Given the Fed's behavior since last August, which has consisted not only of the most aggressive rate-cutting in the history of the Fed, but also (1) the orchestrated bailout of Bear Stearns; (2) the opening of the discount window to securities firms; and (3) the acceptance of mortgage securities as collateral for borrowings from the Fed, we would not be turning bullish on the U.S. dollar on the notion that the Fed has reached the end of its easing/reflation campaign, or has suddenly grasped the importance of sound money. Rather, the dollar had become so oversold and maligned that it was due for a bounce, in spite of the reflationary efforts of the Fed and the federal government.

Turning back to gold, it can be expected to remain under pressure if present trends (rising dollar, rising stocks, rising Treasury yields, contracting credit spreads) persist into May. For investors who have no exposure to gold, the present decline should be viewed as a buying opportunity, with the $800-$840 range being an attractive area to accumulate longer term positions.

Comments

[Pangaea]

A well put-together piece - thank you.