Never Stop Worrying

3/1/2010


The averages have moved within 5% of the January highs, helped by Federal Reserve Chairman Ben Bernanke’s assurances that short-term interest rates are not headed higher anytime soon. With fourth-quarter earnings season drawing to a close, near-term trading will be dominated by news regarding the economy, inflation, and interest rates. Subscribers should hold 20% to 25% of equity portfolios in a short-term bond fund.

Interest-rate outlook

With Bernanke’s latest reiteration that economic conditions are likely to warrant “exceptionally low” short-term interest rates for an extended period, financials and other rate-sensitive stocks rallied. Some analysts argue that investors should stop worrying about rising interest rates, as the Fed is unlikely to tighten with unemployment so high and inflation so low.

The Fed expects the U.S. economy to grow 3.0% to 3.5% in 2010 and 3.5% to 4.5% in 2011 — not fast enough to bring a sharp drop in the unemployment rate from today’s 9.7%. Meanwhile, U.S. consumer prices are barely rising. In fact, consumer prices fell 0.1% in January excluding food and energy, the first drop in so-called core prices since 1982.

While a rate-hike campaign from the Fed seems unlikely in the near term, investors should never stop worrying about interest rates. The Fed has announced plans to stop buying Treasury bonds and mortgage-backed securities this year, and many worry that long-term bond yields will jump without the Fed’s support.

Because long-term bonds represent competition for money that might otherwise go into stocks, a jump in bond yields could put pressure on the price/earnings ratios investors are willing to pay for stocks. Indeed, the low level of bond yields relative to P/E ratios is among the most convincing arguments on the bullish side.

Some simpletons argue that stocks are overvalued because the official trailing P/E of the S&P 500 Index is more than 21 — far above historical norms. But the median P/E of S&P 500 stocks is about 16, below the norm of 18 since 1990. Based on current-year expected earnings, the median P/E is about 15.

Conclusion

For now, subscribers should hold 20% to 25% of equity portfolios in a short-term bond fund and look for buying and selling opportunities one stock at a time. A move in 10-year Treasury bond yields above the June high near 4% would be a negative development, while a move above the January highs in the Industrials and Transports would bode well for near-term trading. For new buying, Raytheon ($56; RTN) seems particularly timely.


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