Three Favorite Investment Themes

Stocks have bounced around this week. They jumped on Tuesday because of increased evidence and/or hope of an improving economy. But they tumbled on Wednesday because of rising interest rates and concerns about the dollar and inflation. Today the trend was up again, led by energy and metals.

Energy, inflation protection and international diversification as a hedge against a weak dollar are three of the related investment themes we discuss in the upcoming issue of Leeb's Income Performance Letter.

The risk of rising interest rates is directly related to all three themes. U.S. Treasury yields have surged to their highest levels since November. This spring alone, they've jumped from 2.55 percent to over 3.7 percent. The gap between yields on two-year Treasury notes and 10-year notes has widened to a lofty 2.75 percentage points.

A sharp rise in overly depressed Treasury yields—they bottomed at 2.1 percent for 10-year issues in late December—was inevitable and is even welcome on some level because it reflects at least a partial return to more normal conditions.

It's generally agreed that the Federal Reserve's massive economic stimulus has been necessary under the dire circumstances that have prevailed. But along with this acknowledgement has come fear of higher inflation. And worries about inflation and its implications have accelerated since last week, when Standard & Poor's warned that the United Kingdom needs to get its finances in order or lose its AAA credit rating. Moody's Investors Service affirmed the U.S.'s triple-A rating yesterday, despite "significant deterioration in the U.S. government's debt position."

The U.S. dollar's standing as the world's reserve currency provides some protection against the loss of its AAA rating any time soon. But the message is clear: Currencies of debt-bloated economies face stiff headwinds. Investors have also been moving out of the relative safety of Treasury securities and into vehicles that pay higher yields or offer greater appreciation potential.

But rising Treasury yields because of falling prices result in higher mortgage rates too, potentially hampering the Fed's efforts to stimulate the economy by keeping borrowing costs low. It also increases the cost of federal bailout efforts, possibly leading to even more borrowing, higher interest rates, a declining dollar and rising inflation.

Consumer Confidence: Is the Bottom In?

U.S. consumer confidence has improved sharply this month, according to The Conference Board. Its index of consumer confidence for May jumped to 54.9, compared with 40.8 in April. The index is now at its highest level since September 2008, right before the economy went into a nosedive and sent the confidence index to an all-time low.

The consumer confidence numbers showed their biggest one-month improvement in more than 6 years, and the increase over the last three months is the largest on record. But the index remains historically low—its average reading has been 95 since 1977.

The present situation index, a gauge of consumers' assessment of current economic conditions, edged up to 28.9 from 25.5 in April. But consumer expectations for economic activity over the next six months jumped to 72.3 from 51.0.

Consumer confidence is still in a recession, but at least consumers are not as depressed as they were a few months ago. The two big questions now are (1) will the increasingly widespread belief that the economy has stabilized prove true and (2) will the economy actually start to improve later this year?

It appears that consumers increasingly think the worst is now behind us. It's still too soon to say that actual growth will resume in 2009.

But Home Prices Continue to Drop

The U.S. housing market remains under heavy pressure, with meaningful improvement not yet in sight.

U.S. home prices continued their long, sharp decline in March, according to the S&P Case-Shiller U.S. National Home Price Index. For the first quarter, the index posted a 19.1 percent drop from a year earlier. In addition, prices declined 7.5 percent nationwide from the fourth quarter of 2008. Nationally, home prices are roughly at their level of late 2002.

A separate, monthly S&P Case-Shiller index of home prices in 20 large metropolitan areas fell a record 18.7 percent year over year. Prices in all 20 cities showed a decrease in March, led by Phoenix, Las Vegas and San Francisco. Compared with the previous month, prices fell in 17 cities. The 6.1 percent drop in Minneapolis was the largest one-month decrease by a city in the index's history.

Also this week, the National Association of Realtors reported that existing-home sales climbed modestly in April from March as buyers snapped up heavily discounted foreclosure properties. Even so, the median home-sale price slid 15.4 percent from a year to $170,200. The number of unsold homes on the market climbed 9 percent by the end of April from March. For a new home, the median price dropped in April from 12 months earlier by 14.9 percent to $209,700, according to the U.S. Dept. of Commerce.

Today, the Mortgage Bankers Association said that mortgage delinquencies and foreclosures rose to records in the first quarter. The U.S. delinquency rate jumped to a seasonally adjusted 9.12 percent from 7.88 percent, the biggest-ever increase, and the share of loans entering foreclosure rose to 1.37 percent. Both numbers are the highest on record going back to 1972.

On the bright side, existing-home inventories, at 9.8 months' supply, have come down from their recent peak of 11.3 months. But there's also a hefty "shadow inventory" of bank-owned residential real estate waiting to be sold.

We continue to see evidence that lower-priced homes, including but not limited to foreclosures, are moving briskly. But the market for expensive properties is sluggish in most localities.

Home prices, along with jobs, are a key to recovery of the broad economy.