The good feeling on Wall Street that had stock prices at 2½-year highs on Thursday came to an abrupt halt on Friday, as unrest in the streets of Cairo served to remind investors of the risk side of the risk/reward calculation implicit in every investment. Crude oil prices shot higher by nearly $4 a barrel on fears of what turmoil in the Middle East’s most populous nation could mean, and share prices ignored evidence of a stronger U.S. economy, falling by the most for any single day in nearly six months. The Dow’s Friday decline amounted to 1.4%, while the S&P 500 (‑1.8%) and Nasdaq (‑2.5%) were even weaker; for the week, the Dow lost 0.4%, Nasdaq lost 0.1%, and the S&P 500 managed to cling to a 0.1% at the close. The abandonment of risky assets, if only for the day, redounded to the benefit of Treasury bonds, where the 10-year T-note gained half a point in price, its yield dipping to 3.33% from 3.36% Thursday and 3.41% at the end of last week. Treasury bonds rallied for two days to end the week, and a week that looked like a clear winner for stocks ended with the Barclays U.S. bond market aggregate’s total return index up 0.4% for the week, 30-80 basis points ahead of the big three stock market averages.
The economic news was mixed Friday, with GDP reported to have increased at a 3.2% annual rate in the fourth quarter of 2010 – ahead of the Q3 rate of 2.6%, if a bit under Street expectations closer to 3.5% – and consumer sentiment was slightly lower in January than in December, although not as much lower as the Street had expected. The GDP report had something for everyone, ranging from a 7.1% rate of increase in final sales to a 0.3% decline in gross domestic purchases: business inventories were drawn down in the quarter, which subtracted 3.7% from Q4 GDP but which also favors a solid GDP increase in Q1 2011; and net imports got a lot less negative in Q4, resulting in a 3.4% boost to GDP. So inventories and foreign trade basically offset each other in Q4, leaving 3.2% GDP growth – respectable but not so solid as to have much of an effect in bringing down the unemployment rate. What was clearly better, or at least stronger, in the fourth quarter was consumer spending, which rose at a 4.4% annual rate, the biggest increase in nearly five years thanks to a year-end jump in car sales. Growth in disposable personal income was hardly robust, at 1.7%, but gains in employment and wages appeared to be quickening somewhat as 2010 changed over to 2011. Business investment in equipment and software increased at a somewhat disappointing 5.8% rate in Q4, which some have theorized may have been due to the uncertainties wrapped up in the elections and future tax policies. On balance, we would describe the GDP report as positive and supportive of an ongoing pick-up in growth during 2011. The chart below shows that there is still a significant output gap between what the U.S. economy is capable of and what is being achieved; this may be though of as pent-up demand, which for a time at least should produce a better rate of economic growth.
INVESTMENT OUTLOOK…The respectable year-end rally in stocks, fashioned out of improvement in leading economic indicators, continued early in 2011, extending the S&P 500’s total return to 100% since the market bottomed in March 2009. With the sudden violence and protests in Egypt, stock market volatility, as measured by VIX, climbed back above 20% Friday, the first time VIX has been that high in two months. To be sure, stock market volatility is still well off the awful levels of 2008-09. But, depending on the turn of events in Cairo, where strongman Hosni Mubarak dissolved his government and ordered tanks into the streets late Friday, while paying lip service to “reform,” we could see investors taking more risk averting measures in the days ahead. Is Egypt the next “black swan”? Let’s hope not for everyone’s sake, although we wouldn’t be surprised if there are occasional bursts of volatility during 2011. For the moment, corporate earnings prospects remain positive, and if worse doesn’t come to worst in Egypt, the general trend of stock prices in 2011 stands to be up.
Copyright © 2011 by Wright Investors’ Service, Inc.