Stocks at 4 1/2 Year Highs: What Does It Mean?

It has been an exciting start to the new year for the bulls. Since 12/30/2005, the SP-500 rose 2.98% to 1285; the Nasdaq leads advance among large caps by gaining 4.55% to 2305, while the Dow Jones Industrials improved by a more modest 1.26% to 10,959.31.

With the exception of large cap technology, small caps continue to outperform large caps. The Russell 2000 gained 3.73% this week. Small caps are known to outperform during this time of the year.

Two reports came this week: the Federal Reserve minutes from mid-December and the employment report. What is important to monitor is not necessarily the numbers themselves, but the market reaction to them. The response of different asset classes to the same economic information can reveal divergent perceptions as to the state of the underlying fundamentals. This is a prime example of information having a different outcome, depending upon the context it is presented.

The first thing to remember this about the payroll and unemployment numbers: unemployment is a lagging indicator, while payroll is a coincident indicator. This makes the payroll indicator slightly more important, in that it will form peaks and troughs which roughly coincide with economic activity. Second, payroll numbers are volatile and hard to predict. Typically, economists, and especially Federal reserve members, focus on a 3 month average of payroll numbersm as opposed to monthly numbers themselves. Third, payroll numbers are subject to frequent revisions as well as seasonal adjustments, and these adjustments are sometimes able to move the markets.

The action of the bond and stock markets will differ, depending upon the state of the market cycle. The bond market reaction is fairly straightforward. Unexpected increase in payrolls and decreases in the unemployment rate are bearish for bonds, which means yields go up. Conventional economic wisdom suggests strong employment means strong economic growth, which could signal increasing inflation.

The stock market reaction to the employment numbers is more complicated, in that it depends upon the state of the market cycle. If stocks have been in a prolonged downtrend, strong employment numbers are bullish, as that implies improved economic growth and improved corporate profits. Yet, stocks can also sell off on strong employment data. If stocks have been trending up (or at least not declining), unexpectedly strong employment data would likely lead to stocks selling off in anticipation of increased inflation and Federal Reserve short term interest rate hikes.

The market reaction to the release of the Fed minutes demonstrates, to me at least, that the market was worried about Federal reserve perceptions of inflation risks. Stock market bulls desperately want an end to the Fed tightening.

Stock bulls received further encouragement with the weaker than expected jobs report. The market appeared to interpret the weak jobs numbers, coupled with low unemployment, as a sign of a so-called "soft landing" where the Federal Reserve can quit with the rate hikes, while the economy coasts along with low inflation and solid growth.

Bonds reacted differently. The 10 Treasury year yield increased 23 basis points, 5 year yields increased 33, while 30 year yields increased 18. This steepening of the yield curve has put many market watchers a bit more at ease. But it begs the question: why were weak employment numbers interpreted negatively by the bond market?

There one possibility I see is that bonds still fear some inflation. Hourly and weekly incomes were up 3.1% from last year. (Bloomberg report).
Keep in mind that both the Fed data and the employment data is somewhat ambiguous. The Fed didn’t really state anything new, and only indicated that future policy would be contingent on future data. The jobs numbers, while somewhat weak, still showed strong enough growth that one could make the case that the Federal Reserve should continue to worry about inflation. At least the bond market response suggests as much.

Regardless, my initial bearish stance should be modified somewhat. The market continues to interpret ambiguous data in a bullish way, telling me that it wants to go up. In a future post, I’ll give a more detailed technical look at how I come to that conclusion.