Friday, October 29, 2010

The 'new normal' rolls on

   While the stock market has been relatively tame the past couple days, the same can't be said for other markets. The Treasury markets recent slide was abruptly reversed this morning when Goldman Sachs announced that the firm expects the Fed to include the purchase of 30-year notes in QEII. This is the first major mention of QEII including purchases of the long bond, which is surprising given its timing and differentiation from recent reports. Considering the WSJ report the other day and now Goldman's take, the potential range and make up of QEII appears to be rapidly expanding only days before the announcement. The 30-year yield ended the week just below 4%, while the 3, 5and 7-year yields finished much lower than their auction yields earlier in the week.

   The big economic news of the day came pre-market as well with the preliminary announcement of 3rd quarter GDP. As expected, GDP in the 3rd quarter grew at a modest 2% clip. Other important pieces of news within the announcement were a 2.6% increase in consumer spending and a core CPI increase of only 0.8%. The consumer spending number while the most positive of the recovery, remains muted compared to pre-recessionary levels. As for inflation, despite the down tick, the U.S. remains in an inflationary world. This is an important consideration when comparing the actions of Japan in a deflationary environment versus the U.S.'s low inflationary position. Separately of note, as long as inflation remains around 1%, bond holders earning less than inflation on 2 and 3 year maturities continue to face real losses. On the whole, those who have predicted a 'new normal'  of 1.5% to 2% GDP growth continue to hit the mark.

   Touching on a few specific stocks making interesting moves, Microsoft reported better than expected earnings after the close yesterday. After opening up about 4%, Microsoft drifted into the close with a gain of a bit over 1%. Just two weeks the stock was facing numerous downgrades as it lagged the market, but since it has rallied over 10%. Looking at tech, IBM played a major role in holding the Dow positive, as it surged over 3% to a new 52-week high. There was little news backing this move and IBM has now erased its earnings related losses. I also want to briefly note the 3M disappointment yesterday morning which has cost the stock around 7%. Most notably the company stated growth in the U.S. and Europe was unimpressive. Given the company's earnings are expected to grow around 9% a year and the stock was trading at a P/E of 15 times next year's earnings, further sell off may be warranted. One last note on 3M, it stands out as one of only a few companies to disappoint and garner some media/market attention. (Maybe a telling sign of widespread optimism)

   While America focuses on the midterm elections and Fed meeting, there has not been a lack of news overseas. On the European front, this morning the EU announced that in September unemployment hit a new 12-year high above 10% and the pace of inflation picked up in October, rising 1.9% from a year ago. Rising inflation in the wake of high unemployment will put the ECB in a very tough position going forward. Meanwhile, CDS spreads on the PIIGS continued their recent rise unnoticed. As for Japan, the Yen rose to its highest closing price ever against the dollar putting further pressure on the economy. Few people today talk of the yen carry trade that aided global growth and rising prices for much of the previous decade. A cautionary note would be to consider the effect of the weaker yen on equity prices and the economy in Japan during that period. Considering that the majority today believe an ever weaker dollar will buoy stock prices and the economy in the U.S., Japan's experience shows that conclusion may not be definitive. While troubles abroad may still be resolved, if the EU and Japan continue to struggle, it will certainly put a cap on global growth for the next several years.

   Next week finally brings some answers to the questions that have been lingering in the markets for a couple months now. Although the near unanimous consensus is that resolution will send the market higher, I worry that the answers may only lead to further questions. If the Republicans win at least one house, how will we respond to structural issues amidst a political stalemate? How long will it take to prolong the Bush tax cuts and what will be extended? If Republicans control both houses, will government spending be slashed at a time when the economy remains weak? If the Fed announces QEII with room for future increases or extensions, will those become assumed as future certainties? How long will the Fed continue pumping liquidity into the economy? Will their actions have any impact?

   From my perspective, the real questions may only begin next week and answers may still be far off in the distance. Therefore, volatility may not decline as the masses expect and movements in various markets may very erratic into year's end.

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