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Stocks Pausing for Breath

The Week Ahead: The market is positioning for year-end. Again, stocks to take a breather. Italy may surprise.

The broad story of the last few weeks is: growth around the corner but also more deficits and inflation. Hence the rise in equities with the S&P 500, Russell 2000, Dow Jones and Nasdaq reaching all time highs together on November 30th for the first time since December 31st 1999. Of course, we all remember what happened next with the Nasdaq spectacularly crashing by 70% over the next three years. Don't worry. There is no sign of a bubble in stocks this time.

And the deficit and inflation fear explains the rise in Ten-Year Treasury yields from a mid-year low of 1.4% to 2.4%. Of course, nothing has changed yet. Growth was better in Q3, but that was expected. Inflation was unchanged at 1.7%, way below the Fed’s target. And employment numbers came in at the steady rate of 178,000 a month. The same rate, pretty much, as the last three years.

1.     There is a big difference between what markets expect and what happens: here are some of the major concerns in the Obama presidency and what actually happened.  

The point is not to mock the predictions. More to show that we're dealing with a wide range of uncertainties. This is the oversimplified version of the Trump era:

The point is not to mock the predictions. More to show that we're dealing with a wide range of uncertainties. This is the oversimplified version of the Trump era:

2.     Meanwhile some good numbers: on growth and employment. Third quarter GDP growth was revised up to 3.2% from 2.9%, with the all important personal consumption number at 2.8% from 2.1%. It looks like this: 

We saw better numbers on personal income and then, on Friday, the latest job numbers. Here they are: 

The unemployment rate is down to its lowest rate since 2007 and the economy seems able to produce enough jobs to keep the Fed happy. It’s not enough to dent the labor participation rate, but that's another story. One striking part was the very low growth in earnings, which rose only 2.4% over the year. So less good for the consumer.

So, this what the Fed faces for its final meeting in Dec 14th: 

So, the only unknown is not whether the Fed increases, but its effect on longer-term rates, which leads us to…

3. The Bond market may have done the Fed’s work: the rapid increase in Treasury yields is unprecedented. Here’s the chart: 

Note that U.S. yields moved almost independently of global rates. This means that spreads between U.S. Treasuries and prime borrowers like the German government have widened to their highest level in 30 years.

Now we know markets can test rationality longer than investors can stand, but it seems to us investors have oversold. It has simply come too fast too quickly. It's a classic case of the “prices changing more than facts”. Not to rain on any parade, but it is unlikely Washington can deliver on fiscal stimulus, tax breaks and faster growth all in the next six months.

4.     Oh and OPEC: agreed to cut production last week by about 1.2m barrels a day. Oil rallied. It’s now up 90% or so from February lows. But, remember, $50 oil is usually enough to trigger a supply response from marginal U.S. producers. So, we don't expect the price level to hold for long.

Bottom Line: We’ll leave you with a final chart, which shows bond and equity yields. 

All this suggests is that in a period of low inflation, when bonds yield more than equities, they are cheap and vice versa. It’s not infallible but again suggests the rapid stock buying and bond sell off may be overdone. 

Other:

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--Christian Thwaites, Brouwer & Janachowski, LLC

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