High Stock Prices, Lower Bond Yields and the Declining Dollar - Which is 'Right' on the Economy?

Includes: AGG, IYY, SHY, SPY, XHB
by: Herb Morgan

Herb Morgan (Efficient Market Advisors, LLC) submits: Recent market action has led many to incorrectly assert that the bond and stock markets are in disagreement about the future of the economy. Considering the action of the dollar, they muse, makes it two to one in favor of a recession. I believe all three markets are acting rationally and are providing us with a nice look into 2007.

Recent bond market strength is a direct reaction to disappointing numbers in Durable Goods Orders (11/28/06), and a rather downbeat Purchasing Managers Report today (12/1/06) which clearly shows a slowdown in manufacturing. True to historical form, it appears that the Fed may have over estimated the effects of its actions on the economy. I expect the Fed will move quickly in 2007 to cut short term rates. Lower rates will be positive for iShares Lehman Aggregate Bond Index (NYSEARCA:AGG) and iShares 1-3 yr US Treasury (NYSEARCA:SHY). Homebuilding and select financials should do well as evidenced by recent action from State Street Spider Homebuilders (NYSEARCA:XHB) up nearly 2% today as the broad market sinks.

The stock market loves earnings and sound currency above all else. The Fed has been adamant that it is a provider of the latter. (As opposed to a social engineering type of Fed). This commitment to fighting inflation provides good currency visibility to the stock market. Earnings however, are going to experience a deceleration in growth over the short term. Current low interest rates justify stock multiples and the prospects of still lower interest rates around the corner provide visibility to support those higher multiples. Lower interest rates will stimulate investment and a rebound in the housing sector.

The positive GNP implications of a falling dollar support the theory that stocks will continue to rise. GNP is composed of Consumption, Investment, Government Spending, and Exports. Imports subtract from GNP. A lower dollar makes imports more expensive to US consumers, and causes US goods to be more attractive to oversees buyers. Every tick down in the value of the dollar makes a revival in US manufacturing seem more likely than not. The lower dollar provides a leveraged effect to GNP as the positive implications of greater exports and lower imports trickle up.

I expect the big stories of 2007 to be a revival in US manufacturing, homebuilding, and a sharp decline in the current account deficit all of which will positively impact equity prices.