In late July, I wrote an article, "Increase in Market Volatility Ahead," where I commented on slowing corporate profit growth and the disconnect between large- and small-company stocks. More specifically, I said, "On days during which large international companies and defense contractors report earnings, you will probably see the major stock market indices rally. But when smaller domestic companies report their second-quarter profits, expect to see stock prices drop." I said that you should start to prepare for a new bear market.
Since then, market volatility has in fact increased, in both the stock and bond markets. For example, the Dow Jones industrial average has risen and fallen several hundred points on numerous occasions during the past month. At the same time, the yield on the 10-year U.S. Treasury Note has fallen to 4.63 percent after rising to a five-year high of 5.26 percent in early June. In addition, the yield curve has resumed its normal shape, with yields on long-term bonds rising above those on short-term debt securities.
You should expect market volatility to continue over the coming weeks, as investors try to sort out the latest developments in the financial markets and the future direction of world economic growth.
Although economies in numerous emerging regions of the world continue to expand at a rapid pace, economic growth has slowed considerably in the United States. And, the U.S. economy will likely continue to slow in the months ahead, after rebounding during the second quarter of this year.
Consumer spending is by far the biggest contributor to the U.S.'s total output of goods and services (GDP), and numerous developments suggests consumer spending will fall sharply over the coming months.
For example, home prices are continuing to decline throughout the U.S. and $500 billion worth of adjustable-rate mortgages are set to adjust upward this year. With the 1-month LIBOR rate currently at 5.50 percent, many homeowners who used adjustable-rate mortgages ("ARMs") to purchase their homes will see their monthly mortgage payments rise by several hundred dollars by the end of 2007.
(Note: Most adjustable-rate mortgages are set by adding a couple of percentage points, called a margin, to the LIBOR rate. Hence, many ARMs are set to rise above 7.50 percent by the end of this year, from less than 6.00 percent only two years ago).
Meanwhile, employment growth has fallen significantly over the past three months and recent help-wanted indices suggest the employment situation may deteriorate considerably in the months ahead.
Although economic growth in China has continued to expand at a rapid rate, inflationary pressures there have risen over the past few months. As a result, China's central bank raised interest rates in China last Wednesday for the fourth time this year.
Central banks in Europe have also continued to raise interest rates in an effort to contain inflationary pressures. However, many economists and stock market pundits expect the Federal Reserve to lower short-term interest rates here, in response to the fallout from the subprime mortgage debacle.
Because of these developments, investors are trying to figure out whether they should continue to allocate money to stocks or whether they should exit the equity markets and invest instead in bonds or precious metals. In my opinion, the best course of action at this time is to wait for clearer signs to develop before allocating additional funds to any particular segment of the market.
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