It struck me why the SP500 index and other stock markets could actually take the next leg down rather than up.  There is room to bounce, yes, but that remains to be proven by the Bulls.  There are reasons the market is nervous and may not rally for a while.  If you have studied stock valuation, you know that a stock’s value represents the discounted value of the company’s future earnings, so:

1. You must know that the companies earnings are going to be stable to growing to project that forward and

2. You must know that interest rates will be reasonably stable.  Generally the 10 year Treasury Note is taken as the guideline.  You always need to know that you will exceed the return on a 10 year Treasury as that is your “risk free” return and stocks have associated risk.  You must be paid for that risk.

So how does this apply?  Because you cannot know #1 above is true at the moment for many companies, particularly tech companies.  You know people will need to eat regardless and use pharmaceutical drugs and electricity, which is why utilities, drug companies, and food/beverage companies have been relatively stable in price during this decline and were doing better prior to the decline.  But you may not need a new computer or new software for the next 3 months if things slow down in the economy even more than they have.

What about point 2 above?  We have NO CLUE about what interest rates will be when the Fed stops QE2.  One GUESS is that rates will float back to where they were when news of it was public.  But where were those rates?  You are guessing high right?  Wrong.  The 10 year Treasury Note was yielding 2.619% and the yield is now 2.909%.  Facinating isn’t it?!  Ironically, interest rates ROSE after the QE2 program was announced and peaked in February at 3.744%.  Since then, the rate has fallen to 2.909% as mentioned.  One guess as to why they initially rose is that the move was considered inflationary.  And we did in fact see food and oil related inflation.

What can we conclude? 

1. Interest rates could actually FALL at the end of QE2 due to deflationary pressures that are arising in our economy.  Oil prices fell rapidly after it became clear that demand was actually not going to hold up as the economy weakened. And perhaps the Saudis have helped at the supply end after Libya stopped pumping oil.

2. Interest rates could rise at the end of QE2.  This is believed to be because China and Japan are no longer buying the Treasuries that the Fed has been buying all along during QE2.

3. The economy could continue to be the source of DEFLATION rather than inflation due to low consumer demand with stagnant employment.

CONCLUSION:  No one can really tell you what interest rates will do on an immediate basis following the end of QE2.  There are opinions that are very strong in both directions, but the above discussion shows you that these are just guesses.  What we do here is follow the markets and let them decide!  What this means is that uncertainty is very high.  That tends to make stock investors wary, because they truly cannot value stocks given that uncertainty. 

Furthermore, the slowdown in the economy could lead to an even greater slowdown adding even more to the uncertainty. What are stocks really worth here?  The market hasn’t got a clue.  And that is why there is still downside risk in the stock markets.  Make sense?

Despite the downside risk, this is why investor sentiment could support a rally from here: Survey Says! Investor Sentiment Could Support Rally

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© 2011 David B. Durand, M.D. All rights reserved.