Now that public opinion is solidifying around the idea that the Federal Reserve has made its last rate cut for a while, stocks may be poised atop a slope of complacency.
Recent activity certainly suggests that this is the case. After achieving double-digit percentage gains since the lows in March as recession fears continued, broad market indexes are showing signs of exhaustion, including a reluctance to react well to positive developments.
The Fed's small April 30 cut was taken as a signal of central bankers' confidence that the worst of the credit/housing crisis had passed, but after an initial burst, stocks sold off sharply in that day's session. Over the next few days, surprisingly strong reports on job growth and activity in the service sector of the economy supported a rosy view, but stocks again were unable to mount or maintain healthy rallies.
That trading pattern – using good news as an excuse to sell – suggests that the buyers have run out of gas and that other investors think there is less to the recovery in stocks and the economy than meets the eye. Robert Arnott, chairman of Research Affiliates, an asset management firm, is one of the skeptics, and he warns that such nervous market action is likely to persist.
Participants in the six-week rally may have underestimated the depth and length of the economy's woes, Arnott said. He calculated that the declines in home construction and second mortgages, hardly the only soft spots, account for 5 percent of economic output.
“It's hard to imagine losing 5 percent of GDP without a recession,” he said.
Arnott also detects excessive optimism on corporate profits, which were so robust until recently. Last summer, inflation-adjusted earnings were 60 percent above their average for the previous decade, he said. Such overachievement occurred only twice in the 20th century, and extreme weakness in earnings and share prices followed each time.
Among the few investments that Arnott is willing to own are utility shares and emerging-market debt. Their high yields, relative to instruments such as Treasury bonds, make them attractive assets, in his view.
David Kelly, chief market strategist for JPMorgan Funds, attributes the sunnier mood on Wall Street, compared with two months ago, to relief that conditions are merely bad instead of horrendous.
“What seems to have happened is that we haven't seen any further big shoes dropping,” he said. “The economy has worsened, but the markets can deal with that. Instead of financial calamity, we're probably going through a mild recession.”
His outlook for earnings is brighter than Arnott's. Consensus forecasts for 30 percent-plus growth in the fourth quarter this year may seem at first like “outrageous predictions,” he said, but the comparison is with the depressed results in last year's fourth quarter.
Kelly finds valuations reasonable, assuming he is right about the economy and earnings. He especially likes technology and health care stocks and favors companies that do a large amount of business overseas.
“I think the stock market is still somewhat cheap if you buy into the notion that any recession will be shallow and short,” he said. “I think that's where we're headed.”
The biggest warning sign for the market may be the lack of concern about all the warning signs that investors were agonizing over just weeks ago.
One indicator of investor anxiety, the Chicago Board Options Exchange Volatility Index, is close to its lowest level since last summer after reaching a five-year high in mid-March. That collective exhalation of breath worries Arnott as much as the prospects for economic growth.
“Investors aren't terrified; they're relieved,” he said. “ 'Relieved' is not a characteristic emotion of a stock market that's about to soar.”
