Stocks, Bonds Are at Odds Over Outlook

The financial markets are supposed to be a good leading economic indicator, an early-warning system for business conditions six months or so down the road.

But the view from Wall Street has seemed particularly muddled since the beginning of 2004. And the action in markets in recent weeks may just add to the confusion over what, exactly, investors and traders think they see coming in the economy.

Last week, stocks had their best rally since November, oil fell to three-month lows, and the dollar hit a seven-month high against the euro. On the face of it, all of that suggested that things are looking up for the U.S. economy.

The Treasury bond market, however, had other ideas: The annualized yield on the 10-year T-note, a benchmark for other long-term interest rates, was threatening to fall through 4% again -- the fourth time it has plumbed those depths in 16 months. The yield ended the week at 4.12%.

Historically, when long-term government bond rates are falling even as the Federal Reserve is raising short-term rates, the message usually is that investors see a sharp deceleration in economic growth on the horizon, or even a recession. Time to lock in those bond yields, they figure.

For people who don’t want to believe that stocks and bonds are in conflict over the economic outlook, there’s a convenient middle ground: the “Goldilocks” scenario, which envisions an economy that’s neither too cold nor too hot, but just right -- enough so that the Fed could soon stop tightening credit.

That may be what many buyers of technology stocks are betting on. Tech stocks have led the market’s rebound since late April, and it wouldn’t make sense to be buying those shares if you thought the business outlook was dimming.

The tech-dominated Nasdaq composite index is up 7.5% from its 2005 low reached April 28. Shares of semiconductor titan Intel Corp. have risen in 15 of the last 16 trading sessions, and at $26.35 on Friday were up 13.6% since April 28.

David Rosenberg, an economist at Merrill Lynch & Co. in New York, thinks the bond market has a much clearer view of the future than tech-stock buyers. He expects the spring weakness in economic data to continue and warns that Wall Street probably isn’t prepared for that.

“We continue to question the pervading optimism about future growth prospects,” he said.

Not so Rosenberg’s peers at Goldman, Sachs & Co., who on Friday declared in their weekly economics bulletin that “the soft patch in U.S. growth is in remission.”

Among the evidence they cited was the sharp rebound in April retail sales. Wall Street too has been pleasantly surprised by the retail trend: A Standard & Poor’s index of seven major department store stocks, including Federated Department Stores Inc. and Nordstrom Inc., hit an all-time high last week.

Given that both the stock and bond markets have pingponged between the perceptions that “things are getting better” and “things are getting worse” since the start of last year -- while the economy has remained on a solid growth track -- it is tempting to dismiss the idea that investors’ trading has any meaningful ability to signal economic shifts anyway.

An old joke on Wall Street, after all, is that the stock market has predicted 20 of the last five recessions.

But markets do get the foretelling job right often enough to warrant paying heed.

Case in point: Share prices plunged in the fourth quarter of 2000 and the first quarter of 2001, preceding the recession that began in March 2001. Most investors, still intoxicated by the dot-com mania, didn’t want to believe the bottom was falling out, but it was.

Then, at the start of 2003, even with the invasion of Iraq looming, the S&P; 500 stock index held above the five-year low it had set the previous October. In retrospect, the selling restraint was a powerful sign that the long bear market was over and that investors were expecting the economy to improve in 2003 -- which, of course, it did.

This time around, a strongly bullish market signal would be welcomed by many Wall Street pros who want to believe that the economy (and corporate earnings) can expand well into 2006 without forcing interest rates and inflation higher.

For example, a sustained rally lifting the S&P; 500 above the 3 1/2-year high it set on March 7 probably would give a big boost to economic optimism. The index got within about 3% of that multiyear high late last week.

Some veteran investors see positive signs in the stock market’s ability to hold up as well as it has over the last 16 months, in the face of eight increases in short-term interest rates by the Fed and the recent softness in the industrial sector.

“I think what’s keeping [the market] up is that the underlying economy is better” than what some recent data have suggested, said Robert Bissell, chief investment officer at Wells Capital Management in Los Angeles.

Many investors may be reluctant to buy, but they’re also not willing to dump their holdings because they figure the economic outlook still is appealing, he said.

In the bond market, some market pros say it’s tougher these days to figure what, if anything, swings in long-term interest rates are saying about the economy.

Merrill’s Rosenberg isn’t alone in thinking that, with the 10-year T-note yield back around 4%, a substantial slowdown is looming. A Merrill survey of about 300 professional money managers between May 6 and 12 turned up the most pessimistic view of global economic growth prospects since 2001.

Yet the ravenous appetite that foreign investors, particularly Asian central banks, have had for Treasury issues over the last two years has raised questions about the message in bond yields: Are they restrained by economic fundamentals? Or have they been kept low because foreign central banks, faced with recycling hundreds of billions of dollars from their trade surpluses with the U.S., would buy Treasuries at any yield?

More recently, some investors’ heavy losses in the corporate junk bond market have been a boon to the Treasury market as money has shifted into safer havens.

For better or worse, the trend in interest rates remains one of 10 components of the New York-based Conference Board’s monthly leading indicators index that seeks to predict economic shifts. Stock prices also are in the index, along with such fundamental data as unemployment insurance claims, building permits and orders to manufacturers for big-ticket goods.

Despite criticism that market mood swings are often just that -- and say little about what’s happening in the real economy -- it would be foolish to think that the daily turnover of more than $1 trillion in financial assets isn’t an important barometer of people’s expectations for the future, said Ken Goldstein, an economist at the Conference Board.

“It tells us something,” he said. “You could make a mistake ignoring what goes on” in markets in trying to chart the economy’s course, he said, although he also cautioned that “you’d make a huge mistake to rely on just that one indicator alone.”

As for the leading indicators index as a whole, it hasn’t been telling a happy tale: The April index, reported last week, fell from March’s level, continuing the mostly downward trend since mid-2004. The index now is below its level of a year earlier.

As with the markets, the leading indicators index hasn’t been infallible in predicting where the economy is going, but its record has been quite impressive. Over the last four decades, whenever the index has gone negative compared with a year earlier, almost 90% of the time economic growth has slowed in the following 12 months, Rosenberg said. In five of eight times, recession ensued.

For the stock market, slower economic growth in the second half of this year might not be a problem if investors believe it will mean an end to the Fed’s credit-tightening campaign and will give way to faster growth in 2006.

A recession, however, certainly isn’t in the market’s current forecast.

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Tom Petruno can be reached at tom.petruno@latimes.com. For recent columns on the web, visit www.latimes.com/petruno.