Stocks Pop As Bond Yield Drop

10/4/2010


 

A September to remember has pushed stocks broadly higher, lifting the Dow Transports above their August closing high. While we don’t view the move above the August highs in the Dow Industrials and Dow Transports as a bull-market signal under the Dow Theory, recent market action has been encouraging — and has positioned the averages for a run at this year’s respective highs of 11,205.03 and 4,806.01.

With closes above those points, we’d be inclined to conclude that a bull market beginning in March 2009 is intact, that this summer’s bear-market signal was an error. If one or both averages fail to surpass this year’s highs and then both close below the July lows of 9,686.48 and 3,906.23, a bear market would be reconfirmed. For now, we intend to watch the averages while looking for opportunities one stock at a time. The range of our recommended cash position is being widened to 20% to 30% to accommodate this week’s addition of Altera ($30; ALTR).

Cyclical strength

Recent U.S. economic reports suggest growth remains tepid. But investors are looking on the bright side, betting that sluggish growth and mild inflation will prompt the Federal Reserve to begin another round of bond-market purchases. Yields on 10-year Treasury bonds have dropped to 2.5%, close to the 18-month lows reached in August.

In sharp contrast to August, when stocks were slumping on fears of deflation and double-dip recession, investors now appear relatively sanguine. The economically sensitive Dow Transports and Morgan Stanley Cyclical Index are trading at the highest levels in more than four months, and shares of multinational giants like Caterpillar ($80; CAT) and DuPont ($46; DD) have surged.

Action in the bond market also indicates investors are not betting on a double-dip recession. Corporate bonds have rallied along with Treasury bonds over the past month, suggesting investors are not expecting a recessionary wave of bond defaults. In fact, average prices on high-yield, or junk, debt recently moved above 100 cents on the dollar for the first time since 2007.

With third-quarter reporting season set to begin in the second week of October, investors’ newfound optimism will be tested soon. The ratio of positive-to-negative profit warnings has not been as favorable as recent quarters, but overall earnings-estimate trends remain mostly favorable outside the financial sector.


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