The S&P 500 Index has closed in positive territory 24 of the past 28 sessions and has risen to new highs for the year. If you think that is breathtaking, the Russell 2000 Index has rallied 20 of the past 23 days. A near-term corrective phase would be totally natural at this point and as long as the indices don't give back too much of the gain; that would be a constructive development for possible future gains.
The equity market at any given moment in time is basically one part reality to three parts perception. The perception part (and the reason behind the continued rally) is that 0% interest rates are good news for stock prices. With rates expected to stay low for an "extended period of time", the perception is that is good news all around.
Question we ponder is if 0% interest rates were a cure-all for all that ails the economy then we suspect Japan’s Nikkei Index (where zero percent interest rates have existed for years) would still not be 70% lower than it was in 1989? As we look back to 2009, didn’t the S&P 500 slide 30% in the opening months of the year with the same interest rate policy we have today? It was only when the Federal Reserve began quantitative easing, the government bought shares in the banks and injected stimulus, FASB made changes to accounting rules and the shorting community was sufficiently ostracized that the market made a bottom. Perceptions changed.
Perception is OK as long as the future reality matches up to the at the moment perception. And so far that has happened. Perception continues to match future reality and the market has rallied accordingly. The stock market perceives a robust recovery, which actually may happen. Economic numbers and earnings continue to come in above expectations. So far so good. Of course, there is always a twist.
The bond market's perception is vastly different from the stock market's. If the bond market (which is actually several times bigger than the stock market) is perceiving a recovery as robust as the stock market, intermediate and longer term interest rates should move higher, as they have in every post war recovery; in anticipation of the Federal Reserve raising rates due to strong economic growth. The 10 year treasury rate is the benchmark for the markets as many other lending rates, such as mortgages, are tied to this rate. In June of 2008, the 10 year treasury rate was 3.79%. In June of 2009, the 10 year treasury rate was 3.71%. Where is it today? As of this morning, the rate is 3.66%. At this point, the bond market doesn't expect the economic recovery to be as robust as the stock market perceives. So who has the correct perception - the bond market or the stock market?
If the economy is recovering at more than just a tepid pace, we should begin to see interest rates move higher as smart bond market investors begin to sell bonds anticipating higher rates. At first, the stock market will likely decline as higher rates tend to be a precursor to an allocation move out of stocks and into bonds as yields rise. However, longer term a rising interest rate environment is good for stocks because it signals stronger economic growth and in increase in pricing power for companies; requiring the Federal Reserve to raise rates to slow growth and tame inflation. If interest rates continue to remain steady or move lower, we should except a continued slow recovery and more muted expectations for earnings growth this year. Economic numbers over the next several weeks should give us a better idea of who is right.
