Positive signs growing in spite of fear -- Stocks vs. bonds spreads at 20-year high

The investor fear of more corporate scandal, and worry that the cure might be worse than the disease, has shattered investor confidence, reduced investment managers appetite for risk and tempered expectations about future growth. Already weak stock prices are further pressured by a "sell first, ask questions later" mentality.

As a result, there has been a historic shift in the valuation of U.S. equities relative to government bonds. Today, the earnings yield on the S&P 500 (the inverse of the price ratio) stands at 6.13% while the yield currently available on ten-year treasury bonds is 4.57%.

In other words the yield spread between stocks and bonds is now a negative 156 basis points. The last time we saw this relationship so inverted was in August of 1982 -- a date that also marked the beginning of a 20-year bull market for U.S. financial markets.

While this pessimistic attitude persists, investors can brush aside fundamental factors such as the positive direction of the economy and potential profit recovery. But only for so long.

The stock market's poor performance of late is intertwined with nagging questions about corporate accountability and trust. It can be seen in slipping consumer confidence data, the widening of the equity risk premium and in conversation with investors who feel wronged by the misdoings of a few.

Nonetheless, the data that relates to consumer spending and manufacturing show an economy on better footing. Strong retail sales figures released last week for the month of June coupled with expanding consumer credit and strong new home sales during May suggest that the average household is more optimistic about their own future than the stock market and the confidence survey suggests.

Even the manufacturing segment of the economy, which has been under water for several quarters, is beginning to show improving trends in orders and inventory. We need to look no further than this month's better-than-expected results for factory orders, the Chicago Purchasing Manager's Survey, and durable goods orders.

Since inventory levels remain lean and end demand continues to put in a good showing, we remain comfortable with our forecast for continued expansion in the economy leading us to a sustainable real growth rate of 3% by the fourth quarter.

In the coming weeks, investors and analysts will have their hands full -- poring over a sea of earnings releases that will hopefully shed additional light on various accounting issues as well as provide additional evidence that a more positive earnings environment is developing.

Second quarter earnings are expected to be essentially flat which compares to the year-ago period where earnings were off 17% from the prior year. Remember also that corporate profits measured using the Federal Government's accounting rules (using data taken from the Internal Revenue Service) have already turned in a slightly positive performance in the first quarter.

We remain confident that earnings will continue to turn positive as economic recovery proceeds. These second quarter releases and conference calls are an opportunity for managements to reassure their investors and employees that every effort is being made to avoid such misdeeds and express outrage at those who have violated public trust. Such a grass roots response by company managements should go a long way towards turning the corner on these issues.

The weakened dollar continues to be a source of concern. A sustained and long lasting decline in the trade weighted value of the currency would have an adverse impact on consumption, inflation, interest rates, and would hinder direct investment here and abroad.

We are not at that point, however, and there is little that would suggest a longer-term structural decline in the dollars' value.

Inflation and interest rate differentials certainly do not suggest that the long-term value of the dollar, relative to our largest trading partners, is eroding. Remember also, that the dollar has enjoyed many years of elevated valuation for a variety of reasons and some moderation in the dollar's value may actually help domestic producers who have struggled recently.

Competing currencies including the yen and the euro are not immune from challenges, either. Japan continues to suffer frequent on-again/off-again recessions and the European community still has a long way to proceed in adopting market reforms and finalizing unification efforts. In the final analysis, the U.S. dollar should remain firmly at the top of the list of recognized and credible mediums of exchange around the world.

Last week, President Bush offered several proposals to strengthen corporate accountability.

Congress, regulatory bodies, and industry groups have already begun to mobilize to enact new sets of rules to govern accounting fraud. Along the way, both political parties will seek advantage at the expense of the other. At a time of distress, such grandstanding is harmful. However investors have seen this before and are well aware of how law is made in the United States. It is not pretty.

However, investors should expect to see material changes in the way audits are conducted, corporate boards are assembled, incentives for executive compensation are monitored and reviewed, analysts and investment bankers interact and communicate with the public, and in disclosures required in company's quarterly and annual reports.

Although it may take quite some time to implement all aspects of these proposals, actions are already being taken to strengthen the reporting process. For example, the newly created Corporate Fraud Task Force has begun its work in investigating improper activities; the thousand largest public companies will soon certify that the financial information they submit will be fair and it was accurate; and the Security and Exchange Commission will receive new funds to add personnel in short order.

It is impossible not to recognize that extreme pessimism exists in the marketplace today.

However, we believe that patient investors will be rewarded for staying the course as equity valuations and positive fundamental developments in the economy give way to better performance in the years ahead. For this reason, we are maintaining our bias towards equities despite recent volatility in the equity market.

At the same time fixed income investors should continue to enjoy real rates of return in excess of the inflation rate as inflation remains tame and the Federal Reserve defers rate increases into next year.

Today, the earnings yield on the S&P 500 (the inverse of the price ratio) stands at 6.13% while the yield currently available on ten-year treasury bonds is 4.57%....In other words the yield spread between stocks and bonds is now a negative 156 basis points. The last time we saw this relationship so inverted was in August of 1982 -- a date that also marked the beginning of a 20-year bull market for U.S. financial markets.

Just thought I would throw something out to counter the negative news we are being bombarded with. The way to make in the stock market is still: "buy low, sell high". That will never change.

Sell into a bull and buy into a bear. Someone once told me that the way to make money in the stock market is to do the opposite of whatever your gut instinct is telling you to do. It's not easy but it works. Feels like shopping for wallpaper while your house is burning down.

Just thought I would throw something out to counter the negative news we are being bombarded with.

I didn't even read this when I saw that the biggest joke on Wall Street wrote it. Battipaglia has been calling for the market to be up 10-15% over the last three years. Anyone following his advice over that time would be broke by now. He and Abbey Joseph Cohen should be shown the door and made to do public service for the rest of their lives.

Good points. The fact is that the economy is recovering but the stock market is more of an emotional weather vane than an economic indicator. And right now, the Democrats and their media allies are doing everything they can to convince the emotional that the economy is tanking...because that is the only possible chance they have of averting a disaster in November.

True, some analysts are always calling for a bull market. However, I have been seeing posts here from analysts who probably turned bearish at about 1500 on the Dow. They are now being trumpeted for calling the bear market even though they are really just the stopped watch being right twice a day. The bottom line is that the economic figures are all showing the economy is rebounding at the same time the Dow is heading south. It is only a matter of time before the stock market starts to rebound. Barring any future terrorist attacks, I am willing to bet my investments that my 1-5 year return on stocks will beat the bond market.

...I have been seeing posts here from analysts who probably turned bearish at about 1500 on the Dow.

And I laugh at their "expertise" also...

It is only a matter of time before the stock market starts to rebound.

Do you remember 1966-1982? I don't want to be in that type of market, thanks.

I am willing to bet my investments that my 1-5 year return on stocks will beat the bond market.

I've been in bonds since January 2000. Are we starting the bet from then or now? :)

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