Will Recent Trends (Higher Yields, Higher Dollar) Continue?

by: Finance Banter

As Wall Street tries to scurry out of town ahead of Christmas weekend, there will be plenty of economic data to sift through while finishing off the holiday eggnog. New and existing home sales are at the top of the list as investors may focus just a bit on the continued plight of a still weak housing market. Once the data gets sifted on Thursday, the markets are likely to drift off to sleep until the following Monday, which will kick off the slowest trading week of the year (not that others haven’t been sleepy as well). Strategists are shining up their crystal ball or ouija board to provide clarity to their 2011 prognostications sure to come true.

While I am still trying to find mine (it may be in a bowling bag), this year should make it two years in a row of double-digit gains for the Dow. Of the prior 10 occurrences, only twice in market history (’51 & ’94), did they extend to a third. It should be a sleepy week in the markets, save for the Wed/Thurs economic releases, so we’ll be watching to see if any of the recent trends (higher yields/higher dollar) continue or get temporarily reversed during this holiday-shortened week.

As long as the markets are open and trading, investors are trying to glean every bit of information from the trading day. However, during the two-week holiday shortened sessions, much of the information can be wrong as many have already closed their books for the year and are snuggled comfortably in bed for a long winter’s nap. Over the last five weeks, the markets have made ever so modest gains and may be accused of sleeping themselves. Many of the momentum indicators have come off their overbought readings of early November, yet remain in territory that is worrisome.

The part of the market that is showing the most “froth” would be investor sentiment, which I have been concerned about over the past few weeks. For example, option activity has been very bullish, with many more “bets” placed on rising stock prices than falling. Combining the bulls in both the Investors Intelligence report and Individual Investors result in a “score” over 109. The last time it was this high was just over 3 years ago as the SP500 peaked just over 1500. Certainly not scientific, but a bullish attitude seems to pervade Wall Street as investors are counting on a Fed to keep the monetary spigots wide open for the benefit of investors nationwide.

The bond model remains at a “sell” reading, indicating yields are likely to continue higher over the near term. What is interesting with the higher yields is they are not yet accompanied by higher inflation, which normally occurs. If we do not see the inflationary ramp higher (due to the heavy hand of the Fed), real yields (subtracting inflation) are very high today. This means that the interest collected is far surpassing general price increases. While many will argue with the faults of the inflation reports (see energy/food prices), current yields are well in excess of inflation. One other feature of current yields is the now widening spread between short and long-term rates as a direct result of the fixed short rates near zero and the now increasing long term rates. The rapidly widening spreads tended to reverse after a period of 3-4 months: we are currently in the second month.

The industry group rankings look strikingly similar to early 2008, when basic materials and energy were the stars of the markets. Both began to deteriorate in the hot summer sun of ’08, to an extent foreshadowing the overall market decline. The arguments for their strength today are similar to those then, good economic growth, especially in China/India. The move higher in commodity prices (as measured by the CRB index) is not as dramatic, but it is close. Over the year ending in June ’08, the CRB index rose nearly 50%. Over the past two years the CRB index has increased nearly 90%. Little surprise that energy and basic materials are leading the equity markets higher. However, is the rise sustainable, or will there be a tipping point at which time consumers look for alternatives for energy or alternate food sources as they did during the summer of 2008 when miles driven actually fell? The two groups have only spent the last month at the top, not the nine months that ended during the summer of ’08. An interesting tidbit and one worth watching closely to see if the two groups can sustain their strength well into the New Year and potentially wrecking havoc on the modest recovery.

While I have slowly increased the equity weight in portfolios, I remain concerned that little in the economic backdrop has changed (it is modestly better). Stocks can still trade higher, but a denouement may coincide with the change of the year. Bond investors should continue keeping maturities shorter as guessing when the backup in rates will end could be painful for bond mutual fund investors.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.