Who knows, by the time you read this, the Dow may have topped the 12,000 mark. The celebration will probably not extend far beyond Wall Street and the media that cover events like this. I’m not so sure the average American even cares.

Regardless of how the much the markets are cheered on to those new levels, there are fewer winners than you might expect. By now, most of you realize that the stocks that have propelled the Dow to this and subsequent highs amount to only a third of the Dow membership. Where is the rest of the Dow 30? Shouldn’t the record high be a broad-based celebration?

Altria, by far the best performer has led the way with a steadily increasing rate of return from one peak to another. Three other notable stocks in this elite thirteen (stocks who have actually gained ground since 2000) are financial companies, pushed forward by a very favorable monetary policy and brisk trading revenues.

Yet, besides Altria, no other stock, even among those that have an increased their share value at the end of this five year stretch, has grown steadily year over year.

(The Dow’s price is a weighted average divided by a divisor that takes into account splits. The short explanation suggests it is nothing more than an actual dollar price. Each time the Dow advances, the gain can be considered a dollar increase in the total index. In other words, those top 13 stocks have increased the worth of the trailing equities.)

Priced individually, companies such as Boeing would have given investors concern in 2001 and 2002. Even ExxonMobil would have shaken the average investor's commitment especially if they piled in at the top of the last peak. In fact, the only other business that has posted a steady gain over that five year period is Procter & Gamble.

So why the excitement, if so many stocks in the Dow have under-performed?

The blind enthusiasm created by this bull market, which is still in my opinion, a stock pickers market, is about to change. The question every investor should ask is simple: could this so-called bull market, whose age is now at five years, keep up the momentum, moving forward even as more investors demand higher rewards for the increased risk many of these stocks offer? A quick glance at the S&P 500 shows a much higher price to earnings ratio (currently 30 times earnings) than is considered normal.

Stock prices are now closely related to the underlying value of the companies they represent. If you look back to the year 2000, you will find a period of wide gaps between stock prices and worth. Without that gap, can investors be convinced that the current price is a worthwhile investment? Where is the growth that investors so often seek?

Look back to that old Dow high and you will find investors embracing a belief that technology will lead the growth over the next decade, pharmaceuticals would open the door to a new era of drug care and the consumer would keep retail moving in a the right direction. Had you invested in those ideas, you would not be celebrating this approach to a record.

But you might also argue that oil prices surged, the terror factor needed to be added to the equation, the Fed under Greenspan was forced to make housing the new consumer piggy bank lowering short-term rates to 1%, and the tax cuts, which included a nod to repatriation and a fixed capital gains levy were all necessary if only as a sign of good faith.

The truth behind this market, aside from the four factors mentioned above is the accommodation provided by bond market. Bonds, as we all know, are built upon fear. They are also sensitive to interest rates. Lower the rates and the fear diminishes.

But you might also say that stocks are also sensitive to fear and interest rates. When the rates are low, a company’s valuation will appear much healthier as the future earnings of the business appear better than they might be during periods of higher rates. Investors, free of fear, jump in with both feet pumping the indexes to new highs.

Those low rates also allowed those same firms to borrow money to buyback stock – a method of increasing valuation by removing shares from the public domain, offering cash dividends – splitting the profits among fewer shares gave many investors the illusion of better profits, and of course, increased takeover activity – a clever accounting maneuver that allowed companies to jettison pension obligations increasing the underlying value of the transaction.

Although the stock market is loath to offer thanks to the bond market, a nod is long overdue. Foreign investors have continued to buy bonds at a brisk clip pushing the long-term interest rates lower (compared to short-term) as the prices of the bonds are pushed higher.

Those overseas investors are also sensitive to interest rates. Should American consumers slow down considerably, foreign purchases of Treasuries will fall. The as yet still unknown reaction to that scenario might find foreign investors switching to more secure securities.

Inflation has had some impact on bonds but the event isn’t widespread nor is it broadly based. Even at 5.25%, the current Fed funds rate is not as historically high as it could have been had inflation been more of a factor. There are plenty of conflicting reports that suggest inflation hasn’t slowed the economy enough and still others that have suggested the slowdown, while significant, is not necessarily a precursor to recession. You can find facts and figures to support either case.

But when you factor in the inverted yield curve, recession becomes much more of a possibility.

A cursory glance shows stocks are still the dominant investment. Equities have kept a wary eye on the inflation but not nearly as closely as bond investors tend to do. Enthusiasm will do that.

What bond investors see is based on more historical data. Once the Fed signals an end to rate increases and even if they choose to pause for a significant length of time, the bond market usually reacts with a rally.

Bonds are currently offering a better yield for the short-term investor and that is a telling sign as well. Right now, there is no real reward for investing too far into the future (as stocks suggest). Do bonds see an economy that is slowing too fast? Do bonds see another pop in oil and commodities prices in the near future? Have bonds seen a housing market that will take the resilient consumer further out of the market as it continues to cool?

A bond rally at this point in time depends squarely on what the Federal Reserve does. If bond investors believe that inflation is benign and the Fed will take its time to begin to cut rates, bonds will rally. Should the Fed see something other than that and begin to cut those rates sooner rather than later, equities will have more room to run.

And the winner will be expectation. If you are bond investor, you can expect the worst and you would probably be right. If you invest in stocks, you will expect the best and you too could be right, at least in the short-term. But only one will end up in the winner’s circle six months from now.

But if the yield curve remains inverted beyond the next six-months, you can expect the bond market to be the clear winner, Dow record or not.

© 2006 Paul Petillo
Editorial Archive

CONTACT INFORMATION
Paul Petillo
Blue Collar Dollar.com
Portland, OR USA
(501) 313-5252
Email  |  Website