2/20/2007 – Why has this market rallied?

There was good reason to be cautious in the Spring of 2006: (1) deterioration in the housing market; (2) rising interest rates; (3) shrinking global liquidity, especially Bank of Japan’s move to absorb excess yen; (4) increased volatility in earnings and stock prices during 1Q2006 earnings season; (5) poor employment data plus tepid wage gain figures; (6) high commodity prices; and (7) sticky and elevated inflation.

It seemed like a high-probability event that the housing woes would finally hurt the consumer, corporate profitability would revert to the mean and decline, and valuations of stocks would contract along with the fundamentals. However, these outcomes did not develop, and, in fact, many bullish events played out.

Most importantly, the housing debacle was contained and did not spill over into the broad economy. And just as important, the Bank of Japan backed away from their effort to drain liquidity from the world economy. Despite short-term interest rates moving up to 5.25%, long-term interest rates declined dramatically from 5.5% to 4.5%. Oil fell below $50 a barrel. Rising stock prices helped offset the damage of the housing bust. All three of these events kept the consumer going. As a result, corporate earnings were solid in the second half of 2006. The government discovered that many more jobs had been created than originally thought. Plus, workers were finally seeing meaningful wage increases without a corresponding rise in inflation, which itself was showing signs of moderating. Finally, private equity became a major player in the stock market providing both a psychological boost to investors as well as a floor to stock prices.

Bottom line: the risks were real but fortunately they did not come to fruition.