Tug of War?

There was no “October Surprise” in the fourth quarter but there were plenty of fireworks in November and December as the stock market established new record highs in a sprint to the finish line. The closing high on the Dow Jones Industrial Average occurred on December 27 at 19,945, tantalizingly close to the 20,000 level. The venerable index closed with a price gain (no dividend reinvestment) of 7.9% for the quarter and a stout 13.2% for the year.

It was, however, the November-December sprint that made all the difference. At the close on November 4, the Dow was up a mere 2.7% for the year. Of the remaining thirty-eight trading sessions, twenty-seven registered gains. The Dow Transports, which had been badly lagging the Industrials for some time, also made new highs, thereby confirming the bullish trend. The financial stocks also performed well during the period – another bullish confirmation.

If it was the best of times for stocks, it was the worst of times for bonds as interest rates moved up across the yield curve, thereby precipitating price declines of 10.4% and 5.3% in the thirty-year and ten-year Treasury futures contracts, respectively. The market, as it always does, correctly anticipated the Fed’s move on December 14 to bump the fed funds rate up another one-quarter of one percent. We have for a long time questioned why so many expend so much effort parsing every word of every comment uttered by Fed officials when all they need do is look at market yields. That, however, is not as much fun and would wipe out the cottage industry of Fed watchers.

Commodity prices, a good leading indicator for both stock prices and the economy, were up 3.3% for the quarter, with crude oil leading the way with an 11.4% increase. Precious metals, however, were weak as gold prices slumped 12.4%. Gold often moves inversely to investor confidence while the dollar is more directly related. Hence, it is no surprise that the dollar rallied 7.5%. The buck bull market, however, is getting long in the tooth and a pullback appears in order whilst the precious metals appear to be oversold and probably poised for a bounce.

Like stock and commodity prices, the economy snapped out of the doldrums as real GDP was reported to have grown at a 3.5% annual rate in the third quarter. The fourth quarter, however, didn’t appear to be quite as strong based on the data released thus far. Industrial production was flat in October and down slightly in November. Retail sales were strong in October and weak in November, although the holiday season looked reasonably healthy overall.

Housing starts were likewise stronger early and weaker later. Home sales typically pick up when interest rates start to rise as potential buyers move to lock in lower rates. Higher rates eventually dampen enthusiasm in the sector but we are starting this cycle from historically low levels so it could take some time for interest rates to be a deterrent. Credit availability (or more precisely, the lack thereof), however, is a different question and that could become a negative more quickly than in previous cycles.

Despite the record levels in stocks, the leading indicator composite index has been weak of late and could be pointing to trouble down the road. Meanwhile, the inflation indices, after a long period of deflation, have moved up and are at or near the Fed’s target levels.

In the sporting news, pigs flew, hell froze over and multiple longstanding curses were broken as the Cubs not only made the World Series for the first time since 1945 but also won it for the first time since 1908. Such an occurrence would appear to open the door to many possibilities, but we wouldn’t bet on Vandy winning the college football national championship anytime soon.

In the span of a year, the Fed has raised the funds rate twice by a total of one-half of one percent. The amount is not nearly as consequential as the trend, which is now clearly up as the economy is at or near full employment. Meanwhile, the incoming administration is advocating serious fiscal stimulus in the form of tax cuts and infrastructure spending.

Ours is not the task of deliberating the virtues and vices of monetary restraint and/or fiscal stimulus but to try to assess the fallout from what appears to be an incipient policy tug of war between the White House and the Fed.

Our confidence about the near-term is reasonably high as it appears likely as noted above that the markets that have been strong (stocks, commodity prices and the dollar) are due for pullbacks while rallies should be expected in the markets that have been weak (bonds and precious metals). These moves, moreover, are not likely to be protracted in either magnitude or time. The bull trend in stocks, for example, while much closer to its end than its beginning, appears to have some more room on the upside before the bears gain control. Relative weakness in the financial stocks is likely to precede any such occurrence and that is not in evidence at present.

Meanwhile, on the economic front, the effects of fiscal stimulus are likely to show up before the effects of monetary restraint if tax cuts are passed quickly and made retroactive to the beginning of the year. That would result in withholding tax table adjustments that would immediately put more money in the pockets of the workforce.

Monetary policy, on the other hand, works with a long and variable lag. Should the central bank remain on course with pulling in the reins, the full effect on the economy would not show up until the second half of the year.

The bottom line is that the word, stagflation, which has not been used to describe the economic environment for many years, might come to be uttered more frequently in the months to come.

Weaver C. Barksdale, CFA