Save for the still frigid upper tier of states, spring has sprung! (I’ll save the frozen robin jokes) A bit of celebration was also in the economic numbers released on Friday, as the employment situation is looking much better – good for stocks, bad for bonds. While the guess may have been too low, the actual number added to payrolls was still not huge. With all the monthly revisions, the average twelve-month gain has been falling for a year, after peaking at a rate well below those of the past 45 years. Many will argue that 125k in new jobs is the same as 250 is years past miss the point that the decline in jobs in 2002 was in line or larger than past job losses. Wage growth continues at roughly a 4% clip, a concern, but it merely matches prior peaks since the early 80’s. So is the economy still expanding? Judging by the Purchasing Manager’s index for both manufacturing and services – it is a resounding no. And worse still were the pricing components, at six-month highs. Higher energy prices have offset the good earnings gains and should serve to keep the consumer “under wraps” during the summer months, when oil prices are likely to be well over $3/gal for gas in much of the US. The earnings season opens on Monday as does the equities shot at reacting to the employment report. We may even get more merger/buyout news as well – so like the bunnies in the yard, Wall Street will be hopping.

What makes this market move surprising is that many of our indicators never made it to the bottom of the chart, as is usually the case for a correction. Valuations of the markets remain high, investor sentiment is also high and interest rates are rising – a triple threat that may prevent the markets from rising significantly from here. In fact, over the past five months, the markets have returned Treasury Bill type returns – with a lot more volatility. If things are so bad, why is the market moving higher? Merger/acquisition activity – from Daimler/Chrysler to Tribune – it seems as if no company is immune, so investors are piling in to guess the next buyout. Hedge funds have raised enormous amounts of cash that can be levered multiple times over; pushing whatever market they wish to play in that much higher. All of the above describe the risks, unfortunately one is never sure when the timing may finally occur to push the markets back to more normal valuations and risk profiles. For now, safe is better than sorry – we may miss some of whatever upside exists, but we don’t want to participate in the inevitable decline.

Surprisingly, our bond model remains at a bullish “3” reading, indicating lower rates are ahead. However, since the initial signal in early February, the long bond is actually higher in yield by five basis points. The yield curve has nearly eliminated all of its inversion, indicating a much lower risk for a recession in the months ahead. The concern in the bond market has shifted back toward inflationary pressures, from oil prices to those found in the purchasing index outlined above. We have highlighted the volatility in bonds vs. stocks over the past few weeks, and see little in that trend ending soon. Watch if yields approach 4.9%+ (now 4.75%) – as that level should put heavy pressure on stocks if they haven’t yet declined.

© 2007 Paul J. Nolte, CFA
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The opinions expressed in the Investment Newsletter are those of the author and are based upon information that is believed to be accurate and reliable, but are opinions and do not constitute a guarantee of present or future financial market conditions.

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Paul J. Nolte, CFA
Director Investments
Hinsdale Associates
630-325-7100
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