February 28, 2013

Friskier stock markets are lifting some interest rates

North American’s major stock market indices are showing that the current level of economic risk has become more acceptable. The improvement in the outlook is providing an incentive to buy equities.

The Dow Jones Industrials (DJI) index has climbed to 14,000 and is poised to break its all-time record, achieved in October 2007. The S&P 500 has improved to a similar degree and is testing two (almost equal) previous highs reached in October 2007 and August 2000.

Including NASDAQ, the three major U.S. indices recorded strong year-over-year gains at January 2013’s close, with the S&P 500 +14.2%, NASDAQ +11.7% and the DJI +9.7%.

The increases during the individual month of January — between +4.0% and +6.0% for the three indices — were among the fastest in many years.

Only the Toronto Stock Exchange (S&P/TSX) has performed in a lukewarm fashion. It’s year-over-year increase in January was +1.9%, which was just about the same as its month-to-month gain of +2.0%.

The TSX is lagging behind the American indices largely because the next wave of commodity price increases hasn’t occurred yet. Resource prices depend on how the world economy is doing and even more specifically on China’s activity levels. The latest data from China, on GDP growth and export sales, has become more positive.

The TSX remains 14% below its previous (and all-time) peak which occurred in May 2008. The TSX peaked later than the American indices because raw material prices stayed relatively high even in the initial stages of the most recent world recession.

There’s another set of figure which warrant a close look — the percentage changes for the indices versus their trough levels, which in all four instances occurred in February 2009. According to this yardstick, NASDAQ is the clear winner with a gain of 128%. The S&P 500 is +104%, the DJI +96% and the TSX, only +56%.

Low yields on other assets, such as bonds, are contributing to the run-up in equity prices. Investors are looking to earn higher returns. I’ll have more to say on this in a moment.

NASDAQ is undergoing some interesting shifts in its key company components. Apple Inc. accounts for an out-sized proportion of the NASDAQ index and is not delivering the same share price gains as in the past. Analysts are beginning to talk about the stock in terms of retaining value as opposed to being a trend setter. Apple’s shares have fallen 37% from their peak last September.

The tech stock receiving the most attention lately has been Google. The company is generating close to 50% of all online advertising revenue, whether it be through PC/laptop or mobile phone searches.

Three out of every four smart phones in the world now use Google’s Android operating system. Google has surpassed Apple in mobile technology software. It’s also catching up in number of dedicated gaming and other “applications”. On the hardware side, the company has been surpassed by Samsung Electronics (e.g., with its Galaxy phones).

It’s interesting that Google and Coca Cola Inc. are two of the firms most often mentioned when there is discussion about growing office space demand in Toronto. Both the software developer and the soft drink maker plan to hire more workers, take on more square footage and increase their presences in the city.

In another indication of change in the Information Technology (IT) world, Dell Computers has been taken back into private (as opposed to public) hands, with Michael Dell holding a majority stake. The company has been battered by declining sales of personal computers. Tablets and cell phones, combined with servers and data storage in the “clouds”, are now claiming most of the buzz.

In Canada’s high-tech sector, Research in Motion (RIM) — newly renamed Blackberry — is back in the fray with its Z10 mobile device. The company is working hard to reverse a decline in its fortunes which has seen its share of the world-wide mobile phone market deteriorate to only 5%.

The increasing appetite for equities is shown in the yield on U.S. Treasury bills, with 10-year notes as the bellwether. After falling as low as 1.60%, they have returned to 2.00%-plus.

(The bond market features an inverse relationship. Higher demand drives up the price but lowers the yield. This is the “safe harbor” effect. In times of increased risk, investors will opt for security. Lower demand, when risk is diminished, reduces bond prices and raises rates. )

Ultimately, how well the stock markets perform will depend on the world economy. Over the last couple of years, there have been several false starts. Improving prospects have been derailed by extraneous negative events. These have included sovereign debt crises in Europe, the tsunami in Japan and political infighting in the U.S., resulting in an embarrassing debt downgrade.

Are there negative shocks that could have similar effects this time around?

Yes, of course. For example, if a big bank in Europe fails. Or if China’s recovery stalls. Or if the price of oil skyrockets on account of some Arab world conflict that moves beyond a tipping point.

Or if there is no agreement on spending cuts in the U.S. and automatic “sequestration” (from social programs and/or the military) takes too big a bite out of the government’s presence.

But those are worst-case scenarios and not really indicative of the economic progress that has been made since 2009. For example, a steep slide in existing home prices in Spain finally flattened out in January after three-years of nothing but month-to-month declines. They are down about a third versus their April 2007 peak.

Spanish banks, encumbered with shaky residential loans, have been a major source of financial sector worry on the continent. A necessary round of restructuring has been underway.

The world is gradually shifting from a heightened-risk environment to one offering a more normal anxiety-to-optimism ratio.

For more articles by Alex Carrick on the Canadian and U.S. economies, please see his market insights. Mr. Carrick also has an economics blog. His lifestyle blog is at www.alexcarrick.com

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