Current Strength Gives Hope

Well, I have to say I am impressed with the stock market’s action lately. Just like it was at the beginning of the year, large-cap stocks are taking the lead once again. Frankly, the strength in the Dow and S&P 500 are making me bullish. The big question is, can it last?

In my mind, the only way a sustained rally will develop is if we get great second-quarter earnings and visibility, commensurate with modest interest rate cuts. Now, further interest-rate cuts would serve three purposes: 1) to help the real estate market; 2) to help the manufacturing sector; and 3) to console the equity markets. Even though most of the economic data suggest that the economy is slowing, I’m still worried about inflation. The commodity price cycle is far from over.

Also a good sign in this market is the trading action in smaller, speculative stocks. As I wrote before, action in this area of the stock market has shown noticeable improvement and is a signal that both institutional and individual investors are stepping up their participation in equities.

Not surprisingly, the stock market is very much looking forward to third-quarter earnings results. These numbers could be the catalyst that gets the stock market moving into a new trend.

Recently, stocks have been rallying based on expectations of further interest-rate reductions. I don’t like it when the market plays this game with the Federal Reserve because it is a setup for disappointment down the road. We’ll see how things develop, but the central bank shouldn’t be pandering to the equity market. Many view the central bank’s previous moves as necessary to restore confidence in the credit and mortgage market; but, in my opinion, part of the move was also to assuage the equity market. This isn’t good business practice for a central bank. Price stability is the name of that game and dropping interest rates too much will only create further problems in the future. It’s difficult for central bankers to get it right, but the next quarter is extremely important for monetary policy and the long-run health of the economy and capital markets.