@theMarket: Stocks Make Record Highs Despite a Wall of Worry

Mixed inflation data, higher unemployment claims, steeper bond yields, the unresolved Israeli counterstrike against Iran, and jitters over the election kept the equity averages volatile throughout the week. Despite those worries, the S&P 500 Index and the Dow hit record highs.

 

A bullish stock market often climbs a wall of worry. This week certainly qualified. Investors had to contend with a continued rise in yields on the benchmark Ten-Year U.S. Treasury and poor results of a government auction for that bond. The yield this week hit a high of 4.09 percent and has gone straight up ever since the Fed's 50 basis point cut in the Fed funds rate last month. If the Fed is cutting interest rates shouldn't bond yields go down, not up?

 

The answer revolves around bond market expectations. After last month's interest rate cut, the bet that the Fed would give us even more cuts in the months ahead rose substantially. Many traders concluded that the Fed would follow up that first cut with two more half-point cuts in the next two months, and as much as four more the following year. By the time the Fed announced its first cut, bond yields had already plunged, discounting this rosy scenario.

 

In the meantime, the economy has continued to strengthen by more than most economists have expected. This, I suspect, is a result of increased federal spending, which almost always occurs during a presidential election year. Growth is great, but a stronger GDP  reduces the need for more monetary stimulus.

 

And let's not forget the inflation fight. September's inflation report, the Consumer Price Index (CPI) fell from plus-2.5 percent to plus-2.4 percent, but core inflation (ex-energy and food) increased from plus-3.2 percent to plus-3.3 percent. The Producer Price Index (PPI), however, came in cooler. The two together equated to a big nothing burger as far as the markets were concerned.

 

However, bond traders are growing concerned that stronger economic growth and additional rate cuts could be a recipe for a revival in inflation. They point to oil prices, a key component of inflation, and a lift in commodity prices, which could keep inflation sticky in the months ahead.

 

The spike in the oil price is based on fears that Israel may hit Iranian oil production, while China's new stimulus program is responsible for the spike in commodities. I believe the rise in oil could easily reverse if the geopolitical situation in the Middle East abates but my crystal ball is exceptionally cloudy in that arena. China's growth, however,  may be a more lasting development depending on how successful the government's fiscal stimulus may be.

 

I don't believe one or two more data points between now and the November FOMC meeting will impact the Fed's decision. But I do believe traders got over their skis in anticipating a series of large interest rate cuts through next year. The Fed certainly did not indicate such a plan was on the table. One voting FOMC member of the Fed recently suggested that he would be happy to skip a rate cut at the next meeting.

 

The bond market is still betting that rates will be reduced in November by another 25 basis points although a 50-basis point cut is now off the table. I expect that this month was the trough in inflation progress. Over the next few months, inflation data may show an uptick. If so, expectations for more cuts will rapidly diminish.

 

Despite these worries, equities continued to plough ahead grinding higher and higher as the week progressed. The third quarter earnings season began on Friday with large bank earnings. Investors seemed pleased with the results. Expectations going into the season are that the rate of gain in earnings overall will be lower than last quarter but will bounce back in the fourth quarter.

 

The Chinese stock market, after a nine-day streak of gains, finally succumbed to profit-taking earlier this week. Global investors were disappointed that further fiscal stimulus programs have not been announced. I think this pullback is healthy. Additional gains are in store for that market,  in my opinion, after a short period of consolidation. I also believe that emerging markets are interesting and cheap versus U.S. stocks.

 

As for U.S. stocks, the averages are extended given the spate of new highs. We are also entering the second week of October with the elections less than a month away. The race is too tight to call. My greatest fear is that we may face a protracted period in which the winners are in doubt. I don't think the markets would take kindly to that environment. 

 

Bill Schmick is the founding partner of Onota Partners, Inc., in the Berkshires. His forecasts and opinions are purely his own and do not necessarily represent the views of Onota Partners Inc. (OPI). None of his commentary is or should be considered investment advice. Direct your inquiries to Bill at 1-413-347-2401 or email him at bill@schmicksretiredinvestor.com.