Saturday, May 13, 2006

Weekly Recap

The stock market had a very rough week. Reality finally hit home on the interest rate front.

The S&P 500 index was dead flat on Monday and Tuesday. The reason was simple. The market was awaiting the Fed's policy announcement on Wednesday. Another 1/4% hike in the fed funds rate to 5% was fully expected, and it happened. There were also high hopes that the Fed would give an indication that it would either pause at the next meeting and not raise rates then, or that it would indicate that the rate hikes were over. That didn't happen.

Instead, the Fed policy statement said "some further policy tightening may yet be needed" and that the "extent and timing" was uncertain. The statement also said, to no one's surprise, that the upcoming data would be critical in determining policy. After all, if the economy weakens significantly, the Fed probably won't raise rates again. If inflation picks up, the Fed will keep raising rates.

The problem was that the market was hoping to look past the top of the interest rate cycle while economic growth remained strong. Now, there are by no means any assurances that the Fed won't raise rates again. In fact, if economic growth continues to put pressures on resource utilization, more rates hikes are likely. The market is not likely to get the best of both worlds - strong economic and earnings growth and no more rate hikes.

The S&P vacillated on Wednesday after the announcement and closed down just 2 points.
Then the selling started. The S&P plunged 17 points on Thursday. This was at times ascribed to a continued sharp rise in commodity prices or to a weaker than expected April retail sales reports. But the commodity story is by no means new, and the retail data could have been spun as a reason why the Fed would be cautious. The real reason for the selling was the realization that interest rates are still going higher, perhaps much higher than was priced into the stock market.

The selling continued on Friday, and for the same reason. There was no news, and oil prices were actually down a bit. Yet the S&P dropped sharply again.

This week, it was all about the Fed.

Earnings season essentially closed out. Over 90% of the S&P 500 have now reported first quarter earnings and the reports tail off sharply in the weeks ahead. Oil is holding well above $70 a barrel. The 10-year note yield has backed up to 5.18% from 5.11% at the end of last week as it continues its steady march higher.

The focus in the weeks ahead will be on the incoming data. The market is caught in a bit of a vise. Strong economic data represents a risk in that it may lead to the Fed raising rates. Weak economic data undermines the market optimism about earnings growth. Furthermore, any uptick in inflation data could send tremors through the market. The stock market is not yet priced for further rates hikes which may well be coming. This reality set in last week, and some further consolidation may yet be needed.


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