Sorting Out Wall Street’s Mixed Signals

In a week when the dollar’s value crumbled to record lows, U.S. stocks closed at record highs and bond yields slid to near last summer’s levels.

If this is the penalty for a cheapened currency, American investors seem quite happy to pay it.

After suffering only a mild bout of selling early last week as the dollar collapsed, U.S. stocks and bonds rallied sharply Friday after the government reported that the economy created a robust 318,000 non-farm jobs in February.

The Dow Jones industrial average jumped 52.22 points to a record 4,035.61 and the bellwether 30-year Treasury bond yield dropped from 7.51% to 7.46%, just above the seven-month low of 7.44% set on Feb. 28.

On the face of it, of course, the markets’ action seemed contradictory: If the economy is stronger than expected, then concerns ought to be growing that the Federal Reserve Board will soon weigh in with another hike in short-term interest rates.

Likewise, the dollar’s latest troubles ought to be fanning those rate-hike fires, because higher yields may be the only weapon available to defend the buck in the near term, if the Fed and the Clinton Administration are so inclined.

But as has been the case for the last three months, the economic reports and the markets’ reactions seem to consistently contain a little bit of good news for everyone--or at least, that’s the way many investors are choosing to interpret them. Take the February employment report, for example:

* With unemployment dropping to 5.4% from 5.7% in January, stock investors could take comfort in the idea that the economy isn’t falling off a cliff, which would obviously have negative implications for corporate profits.

* Bond investors saw no new signs of resurgent inflation in the employment report, and thus no good reason to fear higher interest rates. In fact, despite the gain in jobs, the average employee’s workweek dipped slightly in February and hourly earnings were flat--trends that seem to confirm the idea of a moderately growing economy.

* Currency traders, who pushed the beleaguered dollar up modestly Friday, may have been sensing that regardless of the world’s sudden (and somewhat odd) desire to hoard yen and deutsche marks, there is nothing fundamentally wrong with the U.S. economy.

Indeed, economist John R. Williams at Bankers Trust Co. in New York led off a memo to clients on Friday with these simple and soothing words: “Everything’s Fine at Home.”

“We maintain our long-held view that the economy is headed for a ‘soft landing’ in 1995 and that the Fed is near the end of its (credit)-tightening cycle,” Williams said.

The problem for some Wall Street pros is that the divergences in world financial markets are many and therefore disturbing. Market “technicians” are conditioned to expect trouble when stocks, bonds, currencies and gold, for example, don’t follow logical patterns in relation to one another.

“I can’t remember the last time we had such divergences in markets,” said William Raftery, technical analyst at brokerage Smith Barney in New York.

A plummeting dollar, for instance, usually results when foreign (and domestic) investors sell U.S. stocks, bonds and other dollar-denominated securities in favor of foreign securities, thereby trading one currency for another.

But the dollar’s plunge early last week occurred without much more than a scratch on U.S. stocks and bonds. Meanwhile, despite the surge in the yen and the mark, Tokyo stocks hit 15-month lows by Friday, and the key Frankfurt stock index continued its 1995 slump, losing 115.47 points last week to close at 1,994.02.

Similarly, renewed demand for gold last week, which lifted the price $5.30 to $381.80 per ounce for the week, was consistent with the dollar’s slump--but not with the U.S. bond market’s rally. If gold is gaining because of fresh jitters about inflation (as the weak dollar boosts import prices), should long-term bond yields really be headed back down to seven-month lows?

“This is a very unusual market domestically and internationally,” said David Bostian, market strategist at brokerage Herzog Heine Geduld in New York. “There are all sorts of strange non-correlations.”

And for many veteran market analysts, Bostian notes, the knee-jerk way to interpret such confusing signals “is to come to the conclusion that they’re probably bearish,” especially for the high-flying U.S. stock market.

Bernard Schaeffer, whose Cincinnati-based Investment Research Institute tracks bullish and bearish investor sentiment in the stock futures and options markets, says players in those markets have been overwhelmingly bearish of late--a trend that he views through “contrarian” glasses as being inherently bullish.

The dollar’s slide “is the Orange County du jour, the Barings (bank failure) du jour . These are all events that I consider to be tangential for markets, but they’re being thrown totally out of proportion by a Wall Street crowd that wants to be bearish and see a cloud in every silver lining,” he says.

Measuring recent prices of stock index “puts” (a bet on falling stock prices) compared to prices of index “calls” (a bet on rising prices), Schaeffer finds that “people are paying two, three or four times as much to bet on a major decline in stocks as they are to bet on a rally.

“That tells you that the speculators are looking for a big move to be made to the downside,” he says. “But we know that when too many bear market bets are made it can lead to explosive rallies.”

Bostian agrees. It’s too easy, he says, to take the bearish view that the blue-chip Dow and Standard & Poor’s 500 indexes are at record highs only by default--in other words, that those stocks are merely functioning as “safe havens” for a relative few investors who want to own U.S. stocks.

It’s true that “secondary” U.S. market indexes, like the Russell 2,000 index of smaller stocks, still are well below their all-time highs set a year ago, Bostian says, and that market bears point to that as yet another worrisome divergence.

But he sees the rush into U.S. blue chips as the logical leading edge of a bull market move, given the economic backdrop: If you assume that the world economy continues to grow, and you slash the value of the dollar (lowering U.S. export prices and the cost of American labor), then major American multinational companies stand to benefit most.

So why shouldn’t their stock prices be rising, he asks. “There’s a fundamental reason to be in those stocks,” Bostian argues.

Moreover, on a recent trip to Europe, he said, investors there seemed to be warming to the proposition that the latest dollar devaluation is a gift to them, offering an opportunity to buy high-quality U.S. stocks at cheap prices.

Said Bostian: “European investors who I talked with were intrigued with the idea that buying U.S. blue chips is a way to get exposure” to the global economy, at low prices and at far less risk than what’s entailed in emerging-market stocks.

Robert Brusca, economist at Nikko Securities in New York, agrees that the dollar ought to be a screaming buy--not a sell--for foreign investors at these record-low levels, given the near-term fundamentals of the U.S. economy.

“It is hard to imagine anyone really wanting to bail out of dollars at this level,” Brusca says. “Buying them and getting a low currency basis for your U.S. investment (bond, stock, etc.) makes more sense.”

The bears, however, maintain that ignoring the root cause of the falling dollar--America’s huge budget and trade deficits--and focusing instead on certain limited benefits to the private sector of the economy is folly.

Tracy Herrick, market strategist at brokerage Jefferies & Co. in San Francisco, sees the dollar soon resuming its slide, and he believes the Fed will feel compelled to try and bolster the currency with higher interest rates.

“The only thing that can really support the dollar now is higher short-term rates,” Herrick warns. And when three-month Treasury bill yields rise from the current 5.95% to approach 6.5%, he says, investors’ optimistic view of stocks and bonds will change for the worse, and fast. “The bear market (for stocks) begins when rates go up again,” Herrick predicts.

Of course, that’s a refrain heard many times over the past year, and Wall Street bulls say it’s getting old and tired. “It could be that our markets are winning just because they’re winning,” says Smith Barney’s Raftery. “Sometimes you have to take the trend for what it is and not try and over-interpret it.”

Or try and fight it.