Stocks continued their relentless advance last week and while I remain skeptical of the rally, I must admit its persistence has been impressive. All good things must come to an end though as the bond market demonstrated in fairly dramatic fashion just last week. Long term bonds (as measured by the IShares 20+ year Treasury ETF, TLT) are down nearly 10% from their October highs with almost half of that loss coming last week. The loss from the highs equates to about a 1000 point drop in the Dow but you wouldn’t know it from the lack of press coverage. If the stock market dropped that much over a 6 month period it would be on the cover of TIME.

One difference between the stock and bond markets is that individual investors have been piling into bonds for most of the last three years while stock funds have seen persistent outflows. Chasing past performance is a dangerous game that individuals can’t seem to keep from playing. They were burned by dot com stocks, burned by real estate and my guess is that this is just the beginning of the bond market burning. There may be a countertrend rally in the bond market, but it appears to me the top is in. And what a top too; the bond bull market has been almost uninterrupted since the early 80s. Assuming the increase in the size of the monetary base has the same effect this time as it has throughout history, the coming bond bear market could be every bit as impressive as the bull it replaces.

The catalyst for one more rally in bonds may be a softening in the economic data. Last week’s data had inklings of coming weakness and the advantages of warm winter seasonal adjustments may be coming to an end. The economy is surely better than it was a few years ago but with no positive changes in underlying policy it is difficult to see how we could get much more improvement in the long term performance of the economy. As I’ve said before, there are cyclical forces at work in the auto and housing industries, but most of the rise in stock prices is built on Fed inflation efforts which appear to be coming to an end, at least for now. There was no mention of further policy measures in the statement after the most recent FOMC meeting and in an election year, big moves seem unlikely.

A good example of the cyclical and inflationary forces was the retail sales report for February which showed a gain of 1.1%. Excluding, autos (cyclical) the gain was 0.9% and excluding autos and gasoline (inflation) it was just 0.6%. That’s still a decent gain but the higher gas prices go, the less consumers have left over for other items. On the inflation front PPI, CPI, export prices and import prices all rose 0.4% in February which by the way is quite a bit higher on an annualized basis than you can get from one of those bonds that sold off last week. The rate of change for inflation is falling somewhat though so maybe sometime in the next few months the Fed will feel comfortable initiating another round of bond purchases, savers be damned. Financial repression at its finest.

More forward looking indicators last week were not as positive. Business inventories rose 0.7% which was in line with the rise in sales leaving the stock/sales ratio unchanged. Within those numbers though, inventories at the retail level rose 1.1%, more than double the rise in sales. That raised the stock/sales ratio at the retail level to 1.33 which is still fairly lean. On the other hand, if sales soften, retailers would be expected to sell more out of inventory rather than place new orders and that would not be good for growth overall. The Goldman and Redbook retail reports did not show any weakness though so any slowdown appears to still be in the future.

Reports from the regional manufacturing indexes were also mixed. Both the Empire State and Philly Fed surveys rose but both also showed a slowing in new order growth, shipments and unfilled orders. Industrial production for February also showed some weakness, unchanged on the month. Part of that was due to a drop in mining and flat utility output but manufacturing also showed some weakness with a 0.3% rise, down from 1.1% in January. Motor vehicles and parts dropped 1.1% but that was after a very strong 8.6% surge in January. It appears to me that the rate of positive change is slowing. Whether that turns into outright decline is something I can’t predict but it is certainly a first step in that direction.

I remain cautious with regard to investing. Bonds are uninteresting in the extreme and stocks are no longer cheap absent a surge in growth that I can’t see developing. Multiple expansion is a thin reed to hang onto if growth disappoints. Bullish sentiment is still – in some ways – too extreme in my opinion and the higher the market goes the lower the expected future return. At best we are accumulating gains from the future due to artificially low interest rates. At some point, those future expected returns will be so low that the potential reward no longer justifies the risk. For me that point is rapidly approaching if not already passed.

For information on Alhambra Investment Partners’ money management services and global portfolio approach to capital preservation, Joe Calhoun can be reached at: jyc3@4kb.d43.myftpupload.com

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