Stocks Bounce Amid Fed Threats

5/30/2016


After grinding lower for three weeks on earnings and interest-rate worries, U.S. stocks have bounced. A move above the April 20 closing highs of 18,096.27 in the Dow Industrials and 8,109.19 in the Dow Transports would be encouraging, as would sustained strength in technology, financials, and other sectors leveraged to the global economy.

For now, as a partial hedge, we're holding nearly 20% of our buy lists in a short-term bond fund. We continue to find many of our best ideas in consumer discretionary, financials, health care, and technology — four sectors that have lagged this year but look relatively good based on Quadrix® scores, valuations, and 2016 profit-growth prospects.

Yield spreads

Federal Reserve officials have made it clear they would like to raise interest rates this year — if the U.S. economy remains on a growth path. Interest-rate futures now peg the odds of a rate increase by July at roughly 50%, up from 20% a month ago.

While the Fed's surprisingly hawkish commentary did trigger some volatility in U.S. stocks, investors appear to be coming around to the idea. The rate-sensitive utility and consumer-staples sectors have dipped, but both groups remain within 4% of all-time highs. Meanwhile, financials have been helped by expectations of higher short-term rates, which should bolster banks' profit margins.

Also helping stocks has been the bond market's reaction: Yields on long-term bonds have hardly budged. Yields on 10-year Treasury bonds remain below 1.9%, and the yield spread between two- and 10-year Treasury bonds has shrunk to its lowest level since 2007.

Historically, such a narrow spread, or flat yield curve, has been viewed as a negative indicator for economic growth. Today, however, long-term bond yields are being suppressed by foreign investors who face even lower yields in their own countries.

Stocks' earnings yields, or earnings/price ratios, still look attractive relative to bond yields. The yield advantage of stocks over bonds has improved since late 2013, mostly reflecting lower bond yields.

Since 1994, the median earnings yield of S&P 500 stocks has exceeded the 10-year Treasury yield by 1.3%, on average. Today, the spread is 3.3%.

Conclusion

A breakout above the April highs in the Industrials and Transports would be encouraging — and could prompt us to increase our stock-market exposure. For now, we intend to watch the averages while looking for opportunities one stock at a time.


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