Trey, the Fed's model for pricing the stock market is the next 12 months consensus EPS for the S&P 500 divided by the 10-year note yield. my earlier statement that the calculation involved the 30-year bond was erroneous. anyhow, on may 31 the Fed's model put the correct value of the S&P 500 at 951. since rates have risen since then, the current value can assumed to be a bit lower. i agree with you that valuations are not a matter of rationality, if they were, the stock market would be a lot lower than it is. nevertheless it is important to be aware of what the Fed's model suggests to be fair value. the reason for this is that the market has usually experienced sharp corrections whenever it has reached an overvaluation of approximately 20% according to this model. the valuation of the market has never been as far out of tune with the model as it is now; therefore the conclusion that the market may correct further seems prudent. you state that you don't see a real case for rates to go up or even stay as high as they are now. neither do i, or anybody else i know of. the problem with this is that the same argument could have been, and has been made 100, 50 and 25 basis points ago. rates have gone up anyway. markets often trade way ahead of fundamentals. by the time the fundamentals that support a move in a certain direction become known, the better part of the move has already happened. i am much more concerned with a market's technical picture; the technicals of the bond futures contract are horrible. the only positive thing that can be said about it is that it is way oversold and in the vincinity of an important support level. every other technical indicator points to lower prices and thus even higher yields. as of yet, the stock market seems remarkably unconcerned about this prospect. as i have mentioned before, stock prices reflect the expectation of a sizeable rebound in bond prices. if no such rebound materializes, fear will start to enter the stock market and then the *real* correction will hit. looking at the bond market over the last year or so, you will notice that the low in yields occurred around the time of the second easing by the Fed in october. ever since then, the bond market has signaled the expectation that part, or all, of the easings will be taken back. the Fed's decision to lower rates last fall was an emergency measure taken to stop a financial crisis from spinning out of control. unfortunately this has had the unintended side effect of giving further impetus to an already red-hot economy and extending the life of the stock market bubble. it follows that with the emergency behind us, the Fed is now mainly concerned with correcting the excesses that have been created. the argument that the "bond market is doing the Fed's work for it, and the Fed is therefore likely to sit tight" rings hollow to me, because the Fed's policy is reactive, meaning it follows the market. currently the market suggests that we may well see more than one tightening, but that could of course change once the first tightening has happened and more economic data become known. a few more words regarding the stock market: as you probably know, several well-known market gurus (Favors,Shaeffer,Birinyi,Wollanchuck, to name a few) predict that the market will go a lot higher still this year. predictions for the Dow range from 12,000 to 16,000 to be reached no later than this fall. i agree that this is possible, but i shudder at the implications. the problem with the bullish case is that it rests mainly on the consideration that the excesses seen in the stock market this year will be surpassed by even greater excesses. but the stock market has already left every single historic high-water mark, be it p/e's, price-to-book, dividend yields, total market cap vs. GDP, you name it, way behind. no-one ever thought it possible that the speculative mania of the 1920's could be repeated or exceeded, and yet the 1990's have beaten the 1920's in every respect. we should therefore all pray that the predictions of the aforementioned gurus do not come to pass, because if they do, a crash of never before seen proportions is all but assured. it would be much better for both the market's and the economy's long term health, if the market were to correct further or maybe drift sideways for a while to allow fundamentals to catch up with valuations and take some of the pressures out of the economy that have been created by the market's relentless upward path. i am certain that the Fed sees things in a similar light. while AG does probably not want to upset the apple cart too much, i am sure he worries about the bubble and would be happy to see it deflate a bit. the question is whether a gentle setback is at all possible; it could well be that things have gone too far already. if this sounds unduly pessimistic, consider that nowadays there is a vast, trigger-happy online trading crowd that has already proven it's capacity for highly emotional decision-making by driving the internet stocks to previously unimaginable heights. if the same enthusiasm that was displayed on the greed side of the ledger is applied to the fear side of it, than you ain't seen nothin' yet. there is another danger hanging over this market in the form of the baby boomer, so-called 'long term investors'. they have admirably refused to panic during last fall's decline, but no-one really knows where their pain threshold is. rest assured that at some point the preservation of capital will take precedence over the widely touted 'buy-and-hold' strategy.
regards,
hb |
