OUTLOOK '97
MID-YEAR UPDATE
Prepared by Smith Barney
Interest Rate Futures
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The year 1997 started off looking quite ominous for U.S. financial futures markets, with U.S. economic growth accelerating, U.S. employment surging to a multi- year high, wages and income strong, and the Federal Reserve poised to raise rates. As we expected, the bond market spent the early part of the year under pressure, worrying about the implications of such an upbeat economic environment and the looming threat of inflation that it fueled. Bond prices fell to 106-00, basis the nearby futures, and the yield on the 30-year bond probed toward 7.20% going into the second quarter.
The Fed pulled its trigger in late March, raising the Fed funds target rate to 5.50% from 5.25%. The bond market stabilized soon thereafter, soothed by signs of deceleration in the economy and continued good news on the inflation front. Since then, the 30-year bond yield has moved down to the lows for the year, nearing 6.50%, with the nearby futures contract trading toward 114-00.
Looking ahead, the prospects for the economy remain upbeat, with economic growth expected to accelerate once again going into year-end. Whether or not that growth will feed into higher prices, however, remains unclear. With the U.S. expansion now past its six-year mark and prospects for further productivity gains unclear, fear of an acceleration in inflation could resurface. The 6.50% yield level, or 114-00 to 115- 00, basis futures prices, could be a hurdle beyond which the bond market won't be able to probe if data for the third quarter reflect a revitalized consumer. But we doubt that any bond market jitters will last long, carry prices below the 106-00 region or push bond yields through the 7.20% high set in the spring.
As we mentioned in our January Outlook, we continue to see risks to the market lying on either side of a moderate-growth path. Stronger-than- expected growth could unleash another bout of inflation fear. Conversely, weaker-than-expected growth could raise questions about the continued progress on fiscal deficit reduction in much the same way that soft growth has unsettled European bond markets in recent months. Much of the success of deficit reduction here in the U.S. has been a function of strong revenues generated by the buoyant economy. Government expenditures have been reduced, but decelerating growth could reduce tax revenues at the same time that it increases pressure on government spending.
However, if the U.S. economy remains on a path of moderate growth and low inflation, we'd expect the bond market to be able to move toward the 118-00 to 120-00 region, basis the nearby futures, or the 6.00- 6.25% yield on the 30-year bond.
Lisa Finstrom
Treasury Bonds
Bond prices are in an extensive high-level consolidation bounded by the extremes of 1993-94 (122-10 and 96-01). Intermediate-term swings within those boundaries suggest that prices are in a long-term triangle, a pattern that implies an eventual upside exit. In wave theory, one looks for five swings within a triangle, and per our Outlook '97 comments, three swings were potentially complete. Prices since then have declined, fulfilling our expectations for a sideways/lower market.
First- quarter weakness below 109-16 did not result in an expected decline below 104 (the actual April low was 106-12). The decline to 106-12 establishes that level as the underlying benchmark below which we would doubt triangular potential. Prices below 106 support would cause us to abandon this analysis and to adopt a defensive outlook.
A May-June rally staged at a key intra-range level: 112- 26 where the 1996 weekly closing downtrend line coincided with a Fibonacci-related 61.8% retracement of the last (December-April) intra-range swing. Therefore, a decisive July-August move above 113 would further the case that ongoing triangular development is at or nearing an end. Fourth quarter rally potential would be 116-122. Lacking that, the high level stochastic indicator implies a defensive market beyond August.
James Nason
Stock Index Futures
Using closing prices, the S&P 500 has not experienced a 10% correction since October 1990. The S&P 500 currently trades at more than 20 times Smith Barney's 1997 earnings estimate–well above its average p/e of 14.5 over the last 40 years. If the S&P 500 were to finish 1997 at its closing high for the second quarter (898.70 on June 20), its advance for the past three years would represent its best three-year performance in 45 years. These statistics have raised questions concerning the stock market's potential for the next six months.
Historical statistics alone, however, will not cause the stock market to correct. In order for stocks to experience a protracted adjustment, fundamental factors must deteriorate. Over the next six months, the direction of the stock market should be determined by monetary conditions and interest rates, economic growth and corporate earnings, as well as capital gains taxes and the federal budget deficit.
Current monetary conditions are positive. This is one of the most important considerations underlying the basic trend of equities. Thus far, neither short- term nor long-term rates have moved up sufficiently to seriously damage the stock market's basic trend. So long as the Fed does not embark on a series of preemptive rate hikes, monetary measures should support stocks during spasms of profit-taking.
Although economic growth is expected to decelerate along with the rate of S&P earnings expansion, the second-quarter easing in consumer demand is not expected to last. A rebound in consumer spending should help to maintain a fair degree of healthy profit growth, albeit at a reduced rate, despite the lack of widespread price increases. Strong productivity growth, moderate economic growth, and technological innovation are all combining to slow up inflation and keep equities within their longer-term bullish pattern.
Capital gains taxes and the federal budget deficit can also impact stocks. The last two decreases in the tax rate produced lower stock prices one-to-two months immediately following their enactment. On the other hand, the strong economy is helping to affect a significant improvement in the federal budget deficit. Projections of the size of the deficit have come down substantially. Although a decrease in the capital gains tax could temporarily hurt stocks in the short run, the positive effects of a lower deficit help support an interest rate outlook that is beneficial to the stock market.
Although there has recently been renewed interest in many small-cap issues, the performance of larger-cap stocks continues to be helped by the trend toward indexing and the desire for liquidity. These two trends also contribute to the general strength of the stock market. Between now and the end of the year, financial markets are likely to remain anxious about economic data and their influence on the Federal Reserve Board's goal to preempt inflation. Nevertheless, as long as monetary conditions remain positive, wide swings among the popular averages during the remainder of the year should result in positive gains for the stock market for 1997.
Peter Grennan
Our maximum expectations for early 1997 were 778.30, and if the market strength persisted, the 811-816 range, which was honestly not anticipated until the second quarter. A high of 820.40 was registered in February, after which the market had a brief 10.1% decline into a mid-April low. It constituted the first correction of 10% or more since the summer break of 10.7% in 1996. It was not “the sizable correction” we had been expecting in 1997.
Values have ascended rapidly from the April low, which continues to give the monthly price chart a distinctly vertical characteristic. If it were a commodity chart, we would be discussing a blow-off condition, but frankly, this has existed since early 1995, with the current leg from the summer 1996 low growing even more asymptotic in nature. At some point, perhaps late third quarter/early fourth quarter, this will reach a dangerous condition if it persists.
The weekly chart displays a pair of parallel channels, with August 1987 high and the October 1987 low the starting points. The lower channel top posed resistance through the first half of 1996. The upper channel top has thus far failed to contain prices. A weekly close under the channel top is viewed as a precursor to a more serious correction. The channel had a value of 866.95 in the last week of June, and rises at .703 per week. By October 2, it will have a value of 876.792.
S&P 500 Weekly Chart
Barring a close under the current channel high, values appear free to continue vertically higher, with the next channel iteration currently at 1033 and at 1052 by year-end. We cannot state that these levels will be reached, but they should be meaningful long-term resistance, if challenged. Maintaining the 867 level is constructive, basis a weekly close. Failure to do so would point to a break with 783.20, the mid-point of the top channel, targeted as initial strong support. This would represent a 14% decline from current highs.
Rick Lorusso
July 1997 Smith Barney
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