Monday, 7 May 2007

May is here, should stock investors fear?

Stock markets around the world have had a good run lately. However, it is now May. Is it time for investors to sell and go away?

The bull run in stock markets -- now about four years old -- show few signs of ending at the moment. After some volatility earlier this year, most major markets have achieved good gains for the year. The Standard & Poor's 500 Index closed at 1,505.62 last Friday and is up 6.2 percent since the beginning of the year. The rest of the world have done a bit better; since the beginning of the year, the Morgan Stanley EAFE Index is up 8.6 percent in US-dollar terms.

Bulls could be facing a potentially difficult period ahead though. The six-month period from May to October is generally regarded as a relatively weak period for stock markets.

However, according to David Kotok, chairman and chief investment officer at Cumberland Advisors, much depends on what happens to interest rates over this period. In an article on 24 April, Kotok wrote that historically, the May-October period has been particularly painful for stock investors when the Federal Reserve was raising rates. However, when the Federal Reserve eases or remains neutral during this period, there was no obvious negative tendency in stock markets.

We will soon know how the season will kick off with respect to interest rates. The Federal Reserve meets this week and will announce its interest rate decision on Wednesday. It is likely to leave interest rates unchanged as recent economic data have not provided much evidence that the US economy is straying away from the central bank's forecast of below-trend but continued growth with some inflation pressures.

Last week's economic data reporting had started off on a relatively weak note, with the Commerce Department reporting on Monday that personal consumption expenditures rose 0.3 percent in March, less than the 0.4-percent increase in the price index. Personal income, however, rose a strong 0.7 percent.

The week ended with another weak report that raised doubts on the sustainability of that income growth. The Labor Department reported on Friday that the US economy added 88,000 jobs in April, substantially down from the average monthly rate of over 140,000 in the first three months of the year, and the unemployment rate edged up to 4.5 percent from 4.4 percent.

However, employment is a lagging indicator of the economy and the stock market shrugged off the data, the S&P 500 rising 0.2 percent on Friday.

Other indicators released last week appear more positive. Both of the Institute for Supply Management's reports last week were relatively strong. The PMI, its gauge of manufacturing activity, rose to 54.7 in April from 50.9 in March while its non-manufacturing business activity index rose to 56.0 in April from 52.4 in March. Further evidence of a recovery in manufacturing came from a Commerce Department report on 2 May showing that new orders for manufactured goods rose 3.1 percent in March, the biggest gain in a year.

The latest indices of leading indicators are also pointing up. The Economic Cycle Research Institute's Weekly Leading Index increased to 142.4 in the week ended 27 April from 141.1 in the prior week. Its annualised growth rate rose to 4.4 percent, a three-month high, from 3.6 percent the prior week. In April, the Conference Board had reported that its US leading index increased 0.1 percent in March after two consecutive declines.

On the whole, the data, though not conclusive, do not appear to be inconsistent with the view shared by many economists that the US economy could be near a bottom and ready to re-accelerate in the second half of the year.

If anything, inflation concerns could return to the fore. The March PCE price index was mixed, the 0.4-percent rise in the overall index not being confirmed by the core index that excludes food and energy, which was unchanged from February. However, both the ISM manufacturing and non-manufacturing surveys showed increases in the indices on prices in April -- to 73.0 from 65.5 in March for the former and to 63.5 from 63.3 for the latter.

Under the circumstances, the Federal Reserve is likely to leave rates unchanged this week. What happens to interest rates over the subsequent months will depend on incoming data but it appears to me that neither a hike nor a cut should be ruled out at the moment.

However, the Federal Reserve is not the only major central bank to meet this week. The Bank of England and the European Central Bank will announce interest rate decisions on Thursday.

The BoE is expected to raise rates this week after inflation hit 3.1 percent in March, more than a percent above its target. Despite a mixed inflation picture from last week's reports on the manufacturing and service sectors, interest rate futures indicate that traders are expecting yet another rate hike after that this year.

Inflation in the euro area, on the other hand, has remained steady over the past few months, so the ECB will probably leave rates unchanged. However, a hike is widely expected in June and interest rate futures indicate that traders expect yet another hike after that this year. The latest eurozone data show continued strength in the economy and M3 money supply rose 10.9 percent in March from a year earlier, the most since February 1983.

The Bank of Japan meets next week. After some relatively weak data recently on consumer spending, income, industrial production and consumer prices, a rate hike appears unlikely next week. Nevertheless, the BoJ has shown that it is determined to normalise interest rates, so a rate hike some time in subsequent months is likely.

So while the Federal Reserve may be on pause, with the direction of the next move in monetary policy uncertain, there is little doubt that the trend in interest rates in the rest of the industrialised world remains up. Whether this upward trend is enough to derail the ongoing bull market in stocks remains the big question.

1 comment:

David Wozney said...

A "Federal Reserve Note" is not a U.S.A. dollar. In 1973, Public Law 93-110 defined the U.S.A. dollar as consisting of 1/42.2222 fine troy ounces of gold.

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