Last week the stock market set multi-year highs even though economic readings remained mixed. The employment report issued last Friday registered a disappointing reading of only 96,000 net new hires.
A survey by ADP earlier in the week showed a decent increase of 201,000 jobs. Likewise surveys of purchasing managers were lackluster for manufacturing, but more positive for services.
Since economic news likely had little impact on the market, the real catalyst actually turned out to be Europe. The key development was the plan by the European Central Bank to buy additional government debt.
This allowed government bond yields to drop significantly in Italy and Spain. Thus far in September through Monday 10-year government bond yields have dropped about 1 percent in Spain and around ¾ percent in Italy.
Our market has tracked very closely with the direction of government bond yields in Spain and Italy. Early in the year when their yields were dropping our stock market rallied.
During the second quarter when yields in those countries started to rise again our market faltered. In August when yields started to fall, is when our market started its most recent rally.
The reason for the importance of Spain and Italy is that they are relatively large countries. If both of them had a significant economic collapse the whole future of the Euro would be in doubt. A breakdown of the Euro would clearly have global repercussions.
Just because the European Central Bank is buying government debt does not mean Europe’s problems are solved. Our Fed has been purchasing U.S. government debt, and our economy remains sluggish.
In essence what this accomplishes in Europe is averting a crisis in the short term, and giving governments time to work through their budget deficit issues.
The obvious question becomes where will bond yields in Spain and Italy go from here. Clearly a monetary union does not work if interest rates are significantly different in one country versus another. Eventually the interest rates of member countries need to converge.
The unknown is whether the heavily indebted countries will have their debt restructured, meaning losses for bondholders.
For an investor recent developments indicate the risks of a global financial crisis have significantly diminished in the short run. This has reduced uncertainty, and allowed riskier assets namely stocks to rise in value.
However, little has changed on the economic front, as we continue to experience a subdued economic recovery. Also our dollar has recently weakened against the Euro, which leads to higher import prices, notably oil.
This recent rally has allowed the stock market to get closer to fair value, given where interest rates and corporate earnings are. This would imply an investor should not be overweight stocks relative to their normal targets.
Dividend yields on stocks are still relatively attractive compared to yields on government bonds.