Should equity investors fight the Fed?
Absolutely, writes Ed Yardeni last week in a report to clients. The chief investment strategist at Oak Associates is bullish and he isn’t going to let any central bank threat of higher interest rates stand in the way of optimism. “I continue to place my bets on the bull,” he asserts. And just to make sure no one misunderstands, he clarifies his view of the morrow in no uncertain terms: “There is no foreseeable reflation, stagflation, deflation, or recession in my outlook.” Take that, pessimists and nattering naybobs of negativism.

Lest any one think Yardeni has no respect for the Fed’s power in matters financial, think again. He explains that while he’s reluctant to dismiss the time-honored counsel to avoiding sparring with the central bank, i.e., buying stocks when rates are set to rise, the time is ripe for doing just that. Or, to be precise, the adage needs a 21st century makeover, he argues: “Don’t fight the Fed if the Fed is fighting a serious inflation problem.”
And there’s the rub: the current battle with inflation, such as it is, isn’t serious, Yardeni concludes. That is, it’s not serious enough to derail his bullish outlook on stocks. The monetary tightening won’t bring a recession, and so the rise in earnings can roll on, giving equities the fuel they need to climb higher, he tells us.
The consensus outlook for earnings on the S&P 500, by our own back-of-the-envelope calculations, is in fact higher by around 22% vs. the current reported earnings. If the estimates come through as predicted, the price-earnings ratio on the S&P 500, now around 19, would fall to 16, assuming the S&P remains unchanged at today’s close of 1145.98. By the standards of the last decade or so, 16 looks fairly attractive.
But the question on every investor’s lips suddenly is whether those rosy earnings estimates will come true after all. Indeed, after last week’s pummeling of the equity market, it’s getting harder to think like Yardeni. Sure, the market posted a small gain today, though that’s hardly indicative of much after so many declines. The S&P has given back the entire rally since early November, sending out technically bearish signals for the folks who follow the charts.
What can change the negative sentiment? Earnings, of course. Once again, they are the only game left in town, and all eyes will be focused like a laser beam on companies reporting this week. And a busy week it is. The convergence of first-quarter earnings reports hitting the Street and a fresh dose of skepticism and a weak stock market means it’s put-up or shut-up time.
“When the markets struggled for a technical bounce in the morning, that was investors sending a message that we’re either heading toward an economic recession or toward a profits recession,” Hugh Johnson, head of equity trading at First Albany, tells CNN/Money today. “Earnings reports may be positive now, but investors will be very sensitive to any indications that they might not rise in future quarters.”
Perhaps, although there was reason to breath a sigh of relief, for the moment at least. Despite last week’s disappointing earnings news from IBM, not all’s dismal in earnings land. As Reuters today reports, more than half of the 66 S&P 500 companies that reported first-quarter earnings as of Friday beat the estimates, while around 23% fell short, and 20% matched the Streets consensus outlooks.
3M Company’s latest is, by one account, representative of what’s coming, which is to say, hope, the Reuters story also notes. The Street was expecting $1.01 in per-share earnings today for the diversified manufacturer and instead was treated to a small premium when 3M announced actual results of $1.03. “3M’s earnings should relieve investors because it has a broadly diversified exposure to the American economy and that is a bellwether for the market generally,” says Mike Lenhoff, chief strategist at Brewin Dolphin Securities Ltd. in London.
But good earnings alone (assuming that’s what the first quarter will on balance reflect once all the numbers are released) are only one thing weighing on Mr. Market. Inflation, Mr. Yardeni’s comments notwithstanding, is still an issue, and an unresolved one at that.
A bit more resolution comes tomorrow, when the producer price index is released. More than a few dismal scientists are worried that the pace of wholesale inflation could be advancing at a rate that will surprise Wall Street.
Indeed, even the bond market seemed to be hedging its bets…sort of. The yield on the 10-year Treasury Note inched higher today for the first time since last Wednesday. That’s hardly a reversal of fortunes, but perhaps it’s a whiff of things to come. The fixed-income set was apparently spooked by comments from Fed Governor Susan Bies, who said today, “I believe that, while underlying inflation is expected to continue to be low, the Federal Reserve must be more alert to incoming data, and continue to remove policy accommodation at a measured pace, consistent with the incoming data and its commitment to maintain price stability.”
Of course, Bies, in true Fed style, also made another comment that gave aid and comfort to the Yardeni view of the world: “I expect that the economy will continue to expand at a solid pace this year,” she said, via “Though inflation pressures have risen somewhat in recent months, longer-term inflation expectations appear to have remained well contained.”
But no matter which Bies comment seems more influential, that part of the bond market that’s least tolerant of elevating signs of risk continues to build defenses for a coming storm, real or imagined. Consider that the yield on junk bonds, measured by the KDP High Yield Daily Index, continues to march higher at a rapid clip. While traders have generally bought up government bonds for much of April, investors in lesser-quality debt have been quietly but earnestly selling junk bonds this month. As a result, the yield on the KDP benchmark is now above 7.5%, the highest since last August.
One corner of the bond market’s not inclined to fight the Fed, while the other side is. We’re not sure if this is the last battle of the post-bubble wake, or the first scuffle of the new investing era. But whatever it is, the outcome promises to be influential.