Stock Buyers on Strike?

The country’s gross domestic product grew at 4.2% in the first quarter of this year led by consumer spending and business investment in office equipment and software.  The report also showed that inflation rose the most since mid-2001. The number of Americans filing for unemployment insurance for the first time fell to a three-year low while employment costs rose, pushed by the largest jump in benefit costs in twenty years.

As of yesterday 64% of the 1,632 companies in the Dow Jones US Total Market Index had reported earnings.  Their average net earnings from continuing operations are up 30% over the same period last year.  The leading sectors are Basic Materials, Technology, and Industrial with average earnings gains of 105%, 102%, and 54%, respectively.  The worst performing sector so far this reporting period is Telecommunications.  The drag was largely caused by fixed-line (wired) communications.  Wireless Communications are up an average of 40% as cell phone usage grows and carriers add new services.

With the dramatically improving news in the economy over the last 30 days, bondholders have reacted swiftly and strongly.  During that time both short and long-term interest rates have risen almost a full percentage point (.85%).  The intermediate-term U.S. Government bond index is down 6.2% during the same period.  This reaction is likely overdone as the Fed has indicated a strong desire to get this economy moving and to keep it healthy.  An aggressive round of interest rate increases just does not appear in the cards.  But there is not unanimity in the Fed’s ranks.

A recently released study from the Federal Reserve Bank of Atlanta study suggests that the Fed may have been responding to a false alarm last year when it cut interest rates to four-decade lows and held them there over fears of deflation.  The Wall Street Journal points out that the study concludes that much of the drop in inflation between 2001 and 2003 was due to unusual behavior of residential rents and used-car prices indirectly caused by low interest rates.  If the study is correct, underlying inflation may not be as low as it appears.  Further, it suggests that once the Fed begins to raise rates, the unusual behavior of used-car prices and rents may stabilize or reverse, pushing up measured inflation rates, said Jonathan Basile, an economist at Credit Suisse First Boston.

The Chinese government shook up the Asian markets this week when they indicated they would undertake various measures to stem the rapid growth of their economy. South Korea and Taiwan are down 12% for the week, while Japan is down about 6%.  The Hong Kong Index is down a little over 5% on the news of possible tightening monetary policy.

At home equity markets didn’t fare much better.  The NASDAQ is down 6% for the week despite strong earnings reports and fundamentals.  The broader S&P 500 declined 2.2% contrary to good large-cap earnings reports.  Besides the fear of interest rate hikes, the increased violence in Iraq and terror alerts domestically likely contributed to the stock buyer’s ‘strike.’

Given the fundamentals of this domestic and global economy, stocks appear to be the asset of choice.  During the past month bonds declined 1.5% to 12%, depending on maturity and grade.  Real estate trusts declined an average of 16% according to the Dow Jones U.S. Real Estate Index.   Gold fell 9.5% and the dollar gained 5% against the Euro.  Stock returns ultimately follow corporate earnings growth.  Analysts expect earnings for the S&P 500 to grow 8.5% this year, but that number is likely low.

Companies in the Standard & Poor’s 500 index are expected to post earnings growth of 18.3% for the first quarter, according to Reuters Research.  A total of 193 companies in the index have posted results so far, with 78.3% beating analysts’ average forecasts and just 9.3% missing expectations.  Stock investors are content to take a break for the time being, but if earnings results continue to surprise, stock prices will likely rise from here.