06/14/2007 12:00 am EST
Posted June 14, 2007
Was that it? Is last week's mini-correction over already?
Wednesday's big rally, which drove the Dow Jones Industrial Average up by 187.34 points, was followed by a strong opening on Thursday. As I write this, the Dow is up more than 50 points, less than 1.5% off its recent all-time high.
And despite some technicians' quibbles about unimpressive volume, the number of advancing issues on the New York Stock Exchange topped the number of declines by more than four to one.
So, what was it all about? As I argued here last week , it had everything to do with interest rates and nothing to do with the recent selloff in China's markets-which, incidentally, are back near their highs, too.
Two things triggered this low-level panic attack: a stealth sell-off in the US Treasury market over the past few weeks caused yields on the ten-year note to approach the magic 5% number, and a statement by Bill Gross, chief investment officer of PIMCO, that he expected interest rates to move higher in the next few years.
Overnight the mood changed from self-satisfaction to fear of the twin bogeymen, inflation and higher interest rates. The media, from the Financial Times to the Wall Street Journal to CNBC, predictably jumped on the bearish bandwagon, declaring "the end of an era," as one otherwise-perspicacious columnist put it.
But what really happened? Rates on the ten-year Treasury moved from an intraday low of 4.48% in March to an intraday high of 5.32% Wednesday. When it hit that point, buyers stepped in, sparking a rally in both stocks and bonds.
So, all in all, rates rose less than a percentage point from their lows to their highs, reversing the so-called Greenspan "conundrum" and pushing long-term rates above short-term rates in a more normal yield curve. Trading in inflation-indexed Treasuries indicated fear of inflation was not the culprit.
And indeed, the core producer price index (PPI), which doesn't include food and energy costs, rose only 0.2% in May, as expected. That number, released Thursday morning, suggested the Federal Reserve won't raise short-term rates again, as some bears had begun to believe.
But guess what? Even if it did and even if long rates followed, it's not the end of the world for stocks. History shows that as long as the economy grows and inflation remains in check, stocks will eventually rise.
Investors have such short memories, but we had a perfect example of that just a decade ago. Starting in 1994, the Fed, under Alan Greenspan, launched a series of rate hikes which pushed short-term rates above 5%, from 3.25%, out of fear economic growth was heating up.
That triggered a selloff in ten-year notes, whose yields soared from 5.68% in early 1994 to nearly 8% late in the year (see table).
Think of it: 8% rates on the ten-year, an increase in yield of more than two full percentage points. That was a bear market in bonds, folks. And it had its share of casualties, including Orange County, Calif., as you may recall.
So, what did the stock market do during that time? Surely it collapsed, right?
Wrong! As the table shows, the Standard & Poor's 500 stayed locked in a trading range for much of 1994 while the Fed did its dirty work. In February 1995 the S&P sold at nearly the same price-478 (yes, you read that right) as it did in late January 1994.
But by the middle of 1995 it had begun to take off, after the ten-year Treasury's yield fell again, and it never looked back. By the summer of 1998 it had ratcheted up gains of nearly 150% from 1994's levels. After that, the Fed started cutting rates again in response to the Russian currency crisis and the collapse of Long-Term Capital Management.
And by the way, this was not a brand-new bull market. By 1994, stocks had been rallying for more than three years: the S&P 500 had gained 62% from its lows on October 11, 1990, during the buildup to the first Gulf War.
The parallels are remarkable: the S&P has nearly doubled since hitting its low for the decade on October 9, 2002, during the buildup to the second Gulf War.
What lessons can we learn from history?
First of all, as we said, stocks can withstand a pretty sharp rise in interest rates as long as the economy keeps growing, inflation is under control, and investors are convinced the Fed has its eye on the ball.
Second, the conditions right now do not exist for such a sharp rise in rates, because inflation remains comfortably under control and economic growth is pretty good.
If anything, the risk is that domestic growth may slow as somewhat higher rates pinch the troubled housing market even more. In that case, a Fed rate cut may be in the cards again-even if central banks elsewhere keep raising theirs.
But it really doesn't matter-steady as she goes is good enough to keep stocks rallying.
The correction may not be over. We're still in a seasonally weak period, when markets are vulnerable to all kinds of news reports and data releases. In fact, it would be healthy for markets to have at least the kind of 6% correction we experienced last year.
But for most investors staying the course is the way to go. Will rates stay higher than they have been? Probably. But is it the "end of an era"? Hardly.
Comments? Please email us at TopProsTopPicks@InterShow.com.
Howard R. Gold is editor-in-chief of MoneyShow.com. The opinions expressed in this commentary are his own and are not necessarily the views of InterShow.