Tuesday, June 02, 2009

Can the Rally Last?

Headlines in May were far from encouraging. The unemployment rate climbed to 8.9%, initial jobless claims topped 600,000 each and every week, new home sales continued to tumble, existing home prices plunged again, the decline in retail sales was worse than expected, and it became clear that GM would file for bankruptcy. In addition, Standard & Poor’s threatened to downgrade the United Kingdom’s AAA credit rating, which made some investors wonder if the same could happen to U.S. bonds.

Despite all this bad news, stocks climbed higher. The S&P 500 Index is up an amazing 36% from its March 9 low. Even the successful test of a nuclear weapon by North Korea could not dampen investors’ spirits. The accompanying cartoon nicely sums up the situation. The economy may be dying, but at least our portfolios are getting healthier.

To be fair, there were some tiny bits of good news last month as well. For example, existing home sales picked up a bit, and consumer confidence showed some improvement. Other than that, there wasn't much to celebrate. For the most part, this line of thinking explained the rally in stocks: "Things are getting worse, but they are getting worse at a slower rate!"

And what should we make of the sudden rise in interest rates and crude oil prices? The bulls say these are good signs. After all, higher long-term interest rates give us a healthy upward sloping yield curve, which makes it easier for banks to make money. And rising oil prices suggest the recession’s end is near. Investors may simply be betting that demand for oil, which is still down, will soon pick up.

I admit that I, too, have made similar arguments in the past. However, this time I am at least a little worried about these developments. I can't help but notice that a rally in gold prices and a significant weakening of the dollar against major currencies have accompanied the rise in interest rates and the increase in crude oil prices.

Perhaps our creditors are becoming genuinely concerned about the U.S. government's massive budget deficit. Perhaps higher interest rates are needed to entice creditors like China to keep lending us money. Perhaps investors are jumping into oil to hedge against the falling dollar. It seems we have seen this movie before.

Unfortunately, higher interest rates will result in more expensive mortgages. That's not a development that will facilitate a recovery in the housing market. And higher oil prices translate into higher prices for gasoline. That's not something overextended consumers facing falling incomes and rising taxes can easily handle.

The recent rally in stocks has been wonderful, but I don't take much comfort from the fact that things in the economy are getting worse at a slower rate. After all, they are stilling getting worse. I would like to be wrong about this, but I still expect a near-term sell-off in stocks. After such a strong rally in less than three months time, a sell-off would be a healthy outcome. It would provide a test of the market’s lows and give a second chance to all those investors who are still kicking themselves for holding back in March.