Stock Markets Buoyed by Decent Earnings and Interest Rate Cuts

By: Paul_J_Nolte

With all the hand wringing about consumer confidence falling to 25+ year lows, it becomes much easier to understand IF we make the assumption that we are in a recession. Others worry about the self-fulfilling prophesy – if we believe we are in a recession, it will be so. However much of what is happening today was planted over a year ago. This too is the reason for why all the rate cuts made by the Fed have had little impact upon investors and the economy. However, the cuts will eventually have an impact – but that is not likely until later in the year. A complicating factor in today's economy is the lack of lending “interest” by banking institutions.

The earnings season has been decent – with various caveats: predominately international companies reported good earnings. Financial related stocks reported excuses and have been rebuilding their capital base. Companies primarily tied to the domestic economy have struggled. The focus in the coming week will shift from earnings to the economy as unemployment and an influential report on manufacturing. Expectations have been dropping over the past couple of weeks as various reports begin to support a continued weak economy.

The markets have made it to the top end of their three-month trading range – on some better market internals, however IF the markets can break the trading range, it will need to occur on higher daily volume than we have seen for the past couple of months. While the markets have generally gone higher during April, they have done so on lower overall volume, indicating that investors still have not embraced the rise. Many are expecting a new bull market to grow from the current malaise – once the economic ship is righted.

However our largest argument with that thought is the currently still high valuation on stocks. Normally, bear markets end in tears, blood and despair. So far, the only tears and blood has been shed by the financial sector, the rest of the market has acted fairly well over the past couple of months. The current market multiple is still north of 16 times the recent peak in earnings – a number that should be closer to 14 (or even below) to bring the market in the “cheap” range – which would mean a drop of just over 14% from the Friday close. The market psychology remains one that believes whatever economic slowdown we are in is likely to be fairly short and shallow. However, the housing cycle is anything but – and once investors realize this, we could finally get to a cheap valuation in stocks.

Expectations are beginning to grow within the bond market that the Fed is likely to be standing aside once they cut rates this week (by a likely quarter percent). The bond model has flipped negative, indicating that higher rates are likely in the future. As a result, we are beginning to buy bonds with maturities no more than 5 years to maturity.

Commodity prices have come down some, however tensions in the markets remain high – so any news item about shortages will spike prices higher. If the Fed does indeed stand aside after this rate cut, the dollar could rally – as some implicit support from a rate neutral Fed would be beneficial. The key will be comments from the Fed about the current environment and implications for the future – if the door is open to more cuts, the dollar will drop and commodity prices could jump higher. 

By Paul J. Nolte CFA
http://www.hinsdaleassociates.com
mailto:pnolte@hinsdaleassociates.com

Copyright © 2008 Paul J. Nolte - All Rights Reserved.
Paul J Nolte is Director of Investments at Hinsdale Associates of Hinsdale. His qualifications include : Chartered Financial Analyst (CFA) , and a Member Investment Analyst Society of Chicago.

Disclaimer - The opinions expressed in the Investment Newsletter are those of the author and are based upon information that is believed to be accurate and reliable, but are opinions and do not constitute a guarantee of present or future financial market conditions.

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