Market Outlook for June 15, 2004(A)

In our April comment we noted that on the so-called “Fed Model” the stock market was then 33% undervalued relative to prevailing interest rates. We said you could also read the Fed Model as indicating that bonds were 33% overvalued relative to the then-current level of stocks. Our point was that valuation in the markets is always relative. We suggested that both readings would prove partially correct as we expected the markets to move toward fair value through a combination of rising stock prices and falling bond prices (= rising interest rates).
Well, we’re half right so far as bond prices have fallen precipitously, taking the yield on the 10-year U.S. Treasury Note from 3.75% to 4.75% in just over a month. The spur to this price drop/rate rise in bonds was the arrival of the long-awaited recovery in jobs. Over the past three months roughly 900,000 jobs were created, putting the final piece in the economic puzzle of recovery and silencing those who doubted the economy’s vigor.
Why should good news on the economy be bad news for bonds? There are two lines of reasoning here, one of which we buy and one of which we don’t. The one we buy is that the Federal Reserve has been holding rates at artificially low levels to get the economy back on its feet. Three months of strong job growth—following several months of otherwise positive economic news—suggests the easy money policy has succeeded. So the Fed is now free and, indeed, obliged to wean the economy from this stimulus lest it overdo the job. In anticipation of the Fed raising short-term interest rates bonds across the maturity spectrum have declined to various degrees, pushing up interest rates. This is perfectly natural and we see nothing threatening about the current 4.75% interest rate on the 10-year Treasury.
The second line of reasoning behind the bond sell-off is that continued strong economic growth will bring with it materially higher inflation and interest rates. One would think this shibboleth—that growth always brings inflation—had been laid to rest in the 1990s as inflation fell despite sustained, strong economic growth. Apparently it hasn’t, and its adherents have stalled the stock market’s advance for the past four months.
Were inflation on the horizon, however, you wouldn’t expect the prices of gold, copper, aluminum and other industrial commodities to drop sharply, as they recently have. Nor would you expect an economy utilizing only 78% of its productive capacity—as in the US currently—to develop the production bottlenecks that breed inflation.
As for the headline-grabbing topic of oil prices, we think there’s a lot less there than meets the eye. Yes, oil prices are historically high and may remain so. Or they may not, which is why this highly volatile commodity is excluded from the “core” measures of inflation. But even if oil prices remain high, this isn’t 1973. The impact of higher oil prices on the overall economy and cost of living has declined dramatically over the last 30 years.
At the current level of interest rates and stock prices the Fed Model suggests that either stocks are 23% undervalued relative to bonds or bonds are 23% overvalued relative to stocks. We suspect the bulk of the adjustment in bond prices (down) is behind us. With inflation tame and corporate earnings continuing to climb, we expect the remaining move towards fair value in the markets to come largely from rising stock prices.