Negative Economic Reports Can't Stop Recent Market Advances

Dow Jones Up For the Week; Still Down 6.7% For the Year

February 24, 2008
By: Jerry Cole - Retirement, Investment

When you see the market advancing in the face of negative reports from all corners of the economy, it may be telling you that it has reached a point where it is time to invest. For those of you who have stayed invested, it may be signaling that some of the pain is about to ease. Such was the case on Wednesday. After the Labor Department reported its consumer price index rose by a larger-than-expected 0.4% in January (following a similar rise in December) and oil hit over $100 a barrel, the market plunged more than 100 points only to shrug off the negatives and close up 90.04 points for the day.


For the week the Dow Jones Industrial Average was up 0.3% at 12381.02, however it is still down 6.7% for the year. The question now is will the Federal Reserve be able to cut interest rates more in order to stimulate the economy? The rising price index makes this more difficult for the Fed. To put the recent data into perspective, if the price index were to continue at January's rate, it would annualize at a whopping 4.8%! That is 50% higher than the modern average. This puts the Fed in a conundrum. To fight inflation, the Fed normally raises interest rates. To stimulate the economy the Fed normally lowers interest rates.

This pull from both ends has been called by the term "stagflation" and is a condition not seen since the 1970's. As the name implies, it is a condition where there is a simultaneous rise in inflation along with a slowing economy facing a possible recession. So why would the market rise at all under this condition? Because over the long term the stock market values are driven by two fundamental factors - interest rates and expected earnings.

On Wednesday after the negative reports on the price index and oil prices, the Federal Reserve released the minutes of the Jan.29 to 30 meeting of the Fed policy makers and their latest forecast for the economy. In the report the Fed lowered their forecast for economic growth this year to between 1.3% and 2%, half a percentage point below the level of their previous forecast, in October. Investors took the Fed's darker outlook on growth to mean that it intended to cut interest rates at next month's scheduled meeting.

That in a nutshell is what is keeping the market from falling off the cliff. Lower interest rates! What about expected earnings? They are expected to rise at a much slower pace than they have in the last several years, but remember that stocks compete with fixed income (bonds,CD's etc) for the investment dollar. This competition is measured by the bond's yield to the stock's earnings yield. Taking the expected earnings of companies divided by their stock prices results in a yield that is close to, if not exceeding, the yields on fixed income.

As it always is, investing is a difficult proposition. Remember to keep your risk within your tolerance and keep ahead of inflation.

I invite your questions.

(The opinions expressed are solely those of the author and not Gen worth Financial Securities Corporation.)