The Fed left interest rates unchanged during their May meeting which appears to have given the market little to go on. Since the May 20th meeting, the Dow is unchanged and bonds are only slightly ahead.

In our last issue we discussed how the positive forces of disinflation have propelled the stock market higher over the last 15 years. As a continuation of that discussion, market participants must now determine how much lower the inflation rate and interest rates can fall. From 1980-1981, the rate of increase in the level of inflation (as measured by the CPI) fell by 80% (i.e., inflation is still rising but at a slower pace). In 1991 it bottomed at approximately 3% where it remains today from 15+% in 1980.

Subsequently, interest rates fell by like amounts until they bottomed in 1992-1993 with T-bill rates down 80% and long-bond yields down 63% to 3% and 5.63% respectively from 17% and 15%.

The drop in the high levels of inflation and interest rates, which had choked the economy and market during the 1970's and early '80's, appears to have run its course. Although our indicators are pointing towards higher inflation and interest rates because of the strengthening economy, tight labor force, and increasing commodity prices, resulting in an eventual market downturn; there always is the possibility for rates to fall to their previous levels, but how significant of an impact will they have on stock prices if they do, and over what time frame? Investors must answer two questions for themselves: Am I as willing to commit long-term money to the market with the thought that interest rates may fall from 5% and 7% to 3% and 5%, as I was when rates fell from 17% and 15% to 3% and 5%?; and do I expect the effect on stock prices to be the same as during the last 15 years, which were the best ever for the Dow? Our answer to these two questions would be a resounding no!

Momentum Indicators: Bullish

The market's momentum is still strong with the large cap stocks continuing to lead the way. Small cap stocks have gained momentum but it remains to be seen if this can last. Seasonally, the market has a tendency to be weak during the summer months.

Sentiment Indicators: Bearish

Cash levels in equity and bond mutual funds are at 6% and 5.8% respectively, which is a slight improvement. Consumer confidence came in at 127.1 for May, a 28-year high. This is the best showing since 1969. The last time confidence was this high, the S&P 500 fell (-8.50%), small stocks (-25.05%), and bonds (-5.08%).

Portfolio Strategy

Maintain positions in large cap stocks and continue to avoid bonds until rates move above 7-1/2%.

Model portfolio remains at 70% stocks; 0% bonds; and 30% cash.

June 3, 1997
Donald L. Sazdanoff
Sovereign Asset Management
2628 Trotters Way,
Columbus, Ohio

Relocated 06-13-97
Last updated on 06-13-97

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