Click here to subscribe today or Login.
WITH potential mergers able to turn stocks into instant gold mines, investors have entered the second quarter as hopeful buyers of stock, but they also are watching for warning signs. The wrong news from the Federal Reserve or about inflation or oil prices could send people to the sidelines.
Evidence of a strengthening global economy propelled the Standard & Poor’s 500 up 5.4 percent in the first quarter, a hefty gain by historical standards and particularly impressive given the backdrop of devastation in Japan and the threat to oil prices from unrest in the Middle East and North Africa.
Focused on gains in manufacturing and a trend toward modest hiring, nervous investors regained their courage quickly in March and erased the short, 7 percent downturn. They hesitated Tuesday, caught between a weaker-than-expected report on the economy’s service sector and the tantalizing pull of a growing merger-and-acquisition trend, but on Wednesday sent indexes up once more.
Last Monday, for example, stocks rose after an offer by Texas Instruments to buy National Semiconductor lifted that stock from $14 stock to $24, evidence that a suitor could give investors an instant 72 percent gain if they happened to have the right stock.
Yet Paul Nolte, managing director of Dearborn Partners, said there is “uneasiness in the markets.” He noted that in recent days “there have been gains in the morning but declines in the last hours.”
“While not preceding doom, it may mean the markets trade sideways for the next few months, digesting the gains from the August lows,” he said.
Since August, the S&P 500 has climbed 27 percent as economic data has strengthened.
“The U.S. economy is in a very different place, with growth broadening and deepening as the small-business sector gathers momentum and starts, at last, to create jobs,” said Ian Shepherdson, economist at High Frequency Economics.
Even credit is expanding a little, potentially making it possible for small businesses to borrow and hire. “We are prepared to believe that it is now the single most likely outcome,” said Shepherdson.
But with economic strength comes concern. If indeed hiring is picking up, credit is starting to thaw and the troubled small-business sector is able to grow, then the Federal Reserve will be able to stop keeping interest rates artificially low. This is on the minds of economists and investors, who are fully aware that much of the growth has come from temporary tax cuts and the policies of the Federal Reserve to keep interest rates down. Analysts are trying to estimate what will happen when the Fed allows the economy to stand on its own, or ultimately decides to curtail inflation by raising rates.
Credit Suisse strategist Douglas Cliggott notes that stocks fell in August as growth weakened amid reluctance by the Federal Reserve to start a new round of stimulus. The Fed responded with a new round, and stocks soared.
Should the Fed pull away again, or suggest it might raise rates, that could set off another 10 percent decline, said Cliggott. “I think that’s a reason why the P/E (prices of stocks compared with earnings) is not higher, given low rates and low inflation.”
The Federal Reserve meets later this month.
Without the Fed’s policy of keeping rates low, Pimco bond strategist Bill Gross has estimated that 10-year U.S. Treasurys would be yielding 4.5 percent to 5 percent, instead of below 3.5 percent.
Everyone from homebuyers to companies would have to pay more to borrow money, pressure that could restrain growth in the economy, especially at a time when high commodity prices are adding pressures of their own to business operations as well as households.
Economists have calculated that the extra cost of gasoline has, in effect, wiped out the extra income households have been receiving due to a temporary cut in taxes.
“The return to optimism is a little difficult to understand given the deficit woes, wars, oil at a new high and the Fed caught between a rock and a hard place,” said R.W. Baird strategist Bruce Bittles.
Because he sees “so many moving parts to the problems at home and the unstable geopolitical environment,” Bittles said he is on alert to implement defensive strategies if threats seem clearer.
“Should the market breadth deteriorate as the market approaches new highs, we would recommend reducing exposure to stocks by 5 percent,” he said. “If the yield on the benchmark 10-year Treasury climbs to 4 percent, we will reduce equity exposure by 5 percent. In addition, should investor psychology move to extreme optimism, another 5 percent would come off the table.”