RIDING THE ROCKIES-TRADING UPDATE: February 25, 2012-“Climing the Wall of Worry or Sliding Down The Slipperly Oil Slope?”
February 28, 2012 § Leave a comment
Over the past seven months, we’ve heard countless reasons why the current equity market rally and accompanying economic rally is unsustainable. Francois Trahan of Wolfe-Trahan puts it nicely into graphic form, below:
The “hew and cry” from thebears is that gasoline prices will derail this rally.
There is no question but that energy prices are a “tax” on consumption and that in a consumer driven economy, taxes result in lower spending and can have the effect of lowering corporate earnings. However, the bearish case fails to address the impact of lower natuaral gas prices on the economy, as well. Because of a mild winter and increased production, the price of natural gas is very low. The effect is an “offset” against higher oil prices. This is not to say that the bears might not be correct if there were an oil “shock” but for the moment, in a relatively peaceful world, I haven’t moved to the bear’s camp.
That being said, I am, however, thankful for the presence of this very healthy skepticism for it portends a more orderly market advance, as opposed to an ebullent equity market phase which might well signal that we are, indeed, at or near, a top.
I don’t believe that this year’s early stock market advance is a “redo” of last year, which saw strong early gains followed by precipitous volatility and declines up to mid-October. I believe that we are better positioned for a sustained equity market advance for the following reasons: 1. Consumer credit is expanding, not declining as it was, last year. 2. New home construction is expanding more quickly than last year and inventories of housing are being absorbed with low mortgage availability improving. 3. Manufacturing employment numbers continue to improve.
In this chart from Wolfe-Trahan you can see just how closely correlated employment and the S&P 500 are. So, in addition to energy prices and commodity inflation, we are closely watching the unemployment numbers and they have continued to improve over the past several months. That bodes well for a sustained advance in equities.
The ISM numbers also continue to support the thesis that the economy is improving, even in the face of this morning’s durable good number that came in below analysts’ expectations. We watch these indicators closely, but we believe that the odds favor continued improvement in these indicators, which supports a strong equity market case.
The fact that this recovery is not a straight line “up” and that there are headwinds is, I believe, healthy and has prevented the equity markets in this country from becoming too overheated. Valuations, in many cases remain attractive and are tracking the growth of corporate earnings, rather exploding in advance of corporate earnings. So, in an interest rate environment that sports some of the lowest rates in history and a central bank that seems hell bent on election to keep rates low, I view the greater risk today as that of an inflation boom in which interest rates begin to rise rapidly, resulting in millions of investors who have overweighted their portfolios in bonds, suddenly witnessing their bond values decline rapidly. This could result in large-scale selling such as that witnessed last week in the i-Shares National Municipal Bond ETF (NYSE-MUB) and a rapid flow of funds into equities. Should that occur, we’ll probably begin to take equity chips off the table. Until then, however, I am of the opinion that the equity markets will not slide down the slippery slope, but will, rather, climb a wall of worry.