David Joy - Market climb reinforced by fundamentals

Stocks continued to march higher last week after a succession of strong economic reports and the absence of any immediately noticeable adverse consequences from the budget sequester.

Both the non-manufacturing ISM and labor market report exceeded expectations, reinforcing the view that the U.S. economy has gathered some strength since its sluggish fourth quarter performance. It remains to be seen whether such strength can be extended beyond the first quarter. Job growth in prior years has also started out strong, only to slow as the year progressed. And while it may not be the catastrophe some have portrayed it to be, the sequester will be a drag on growth as it begins to take effect.

Nevertheless, stocks pushed higher. The S&P 500 gained 2.2 percent on the week, leaving it 8.8 percent higher on the year, and just a percent below its all-time high. Small cap stocks did even better, rising 3.0 percent as measured by the Russell 2000 index, now higher by 11.0 percent since the start of the year.

The rise so far this year has been mostly uninterrupted. The only period of weakness occurred between the release of the Fed minutes on February 20 and Chairman Bernanke's congressional testimony on February 26, during which the market declined roughly 3.0 percent. If there was any doubt that the market remains dependent upon the largesse of Federal Reserve policy, this episode confirmed it. The minutes seemed to hint at a more hawkish tone at the last Open Market Committee meeting, suggesting a possibly earlier shift in policy than had been widely expected. Seizing upon that apparent misreading, the Chairman made it clear in his testimony that the Fed remains committed to its policies until it sees meaningful improvement in the labor market. In other words, the Fed is not going anywhere, anytime soon. In response, stocks resumed their climb.

Of course, economic fundamentals do matter, and that is why the latest batch of stronger numbers is encouraging. On top of recent strength in housing and manufacturing, the economy's underlying growth rate appears to be roughly 2.0 percent or even a touch better. If so, its ability to absorb the drag from the sequester is sufficient. The stronger data and the stock market’s recent strength also suggest that businesses and investors alike are not only not overly worried about the impact of the sequester on the economy, but may instead be more focused on its salutary impact on the deficit.

If so, then the latest overtures from the White House toward Congressional Republicans regarding a framework for further progress on deficit reduction creates the possibility of a potentially strong catalyst for extending this rally even further.

That said, given the track record of failed initiatives on this issue, and considering how far apart the two parties are, expectations for any kind of breakthrough should be low. And certainly nothing appears imminent. But one can dream.

Treasury yields seemed to confirm the better economic tone. The yield on the ten-year note climbed to 2.05 percent, and the intermediate part of the yield curve steepened modestly. Even the banking sector got into the act last week, as the results of the Fed's latest stress test painted a picture of general health.

If there was anything to temper the good news last week, it was a series of somewhat softer economic data from China, higher inflation in particular. But even there, the news wasn't terrible. And there are likely distortions still in the data from the Lunar New Year holiday. As Francois Trahan of research firm Wolfe Trahan points out, the inverse correlation of U.S. stocks to inflation is quite high recently. Strength in Chinese equities has been a good leading indicator of economic acceleration, higher commodity prices included. After a sharp rally to end the year, the Shanghai Composite index has stalled recently, perhaps foreshadowing more modest growth immediately ahead. If so, commodity inflation may be modest. If so, rather than wishing for a robust recovery in the Chinese economy, perhaps modest, sustainable growth with low inflation is what we should hope for.

There are some important economic releases on the calendar this week that will be watched to see if they tend to confirm the recent strength. On Wednesday, retail sales are expected to be solid but not robust. And on Friday, industrial production is expected to rebound from a slight decline in January.

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