The stock and bond markets are expecting different things for this Yuletide season. The 10-year Treasury bond, which climbed as high as 5.25% in late-June, has since fallen to below 4.5% on concerns that we’ll be talking less about inflation in 2007, and more about the need for an economic recovery. Stocks, on the other hand, have bought into a “soft landing” story that acknowledges the weakness in several economic indicators, but anticipate the Federal Reserve rising to the occasion to cut interest rates and “save” the economic recovery with heroic 9th inning (or is it 6th inning?) moves to reduce interest rates. Bonds are anticipating a lump of coal. Stocks are forecasting a pretty bow. Markets are sending mixed signals and our ETF model is responding accordingly.
In October, the model added long bonds to the portfolio, and those bonds have generally kept pace with the market’s advance since then. Adding bonds is typically a “defensive” move, which makes a lot of sense if we’re about to head into a recession, which should hurt stocks. On the other hand, in December the model replaced defensive “consumer staples” stocks with more aggressive technology stocks, reflecting strength in a sector which hasn’t moved much since 2003, despite impressive growth in earnings power and recent strength in the software and communications equipment sectors.
Market momentum favors stocks in the short run. Year-end and first-quarter money flows also tend to favor stocks. Storm clouds on the economic horizon continue to grow, however. The portfolio is positioned to make money in stocks, while the opportunity lasts. We at Scout Partners offer you our best wishes for a happy holiday season and a prosperous New Year.
Douglas B. May, CFA, is President of May-Investments, LLC and author of Investment Heresies.
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