Stocks surged today, with the Dow Jones industrials and Standard & Poor’s 500 each up about 2 percent. The catalyst was a report that the U.S. economy grew at an annual rate of 3.5 percent in the third quarter. It was the first quarterly growth after four consecutive declines, and it may well mark the end of the worst economic downturn since at least World War II.

 

However, growth is expected to be sluggish, weighed down by high unemployment, tepid consumer spending and a continuing credit crunch.

 

Until today, stocks around the world were struggling for the last week in a bout of long-overdue profit-taking, with broad market weakness. The Dow Jones industrials recorded several triple-digit losses, and the percentage declines in other market indexes were much greater than in the Dow.

 

Here in the U.S., the major reason for the weakness before today was renewed worries about the pace of economic growth in general, and the prospects for consumer spending in particular. The gradual shift by investors from low-risk, low-yield instruments to vehicles with better total-return potential has been the big story since March. This trend, aided by an improvement in corporate earnings, has outweighed concerns about the economy and the consumer.

 

The big test for the stock market now, in our view, is whether consumer spending, which accounts for some 70 percent of the U.S. economy, can mount a sustained improvement. Unfortunately, we have our doubts, which we've expressed often.

 

Now the question is whether we'll see a significant retreat back to safety, throughout the key financial markets—stocks, bonds, currencies and commodities.

 

A renewed flight to safety, if it happens, will likely prove good for the battered U.S. dollar. A weak greenback generally is considered a negative for the U.S. economy, and vice versa. But for much of 2009, the U.S. stock market has soared while the dollar has declined. In the last week, the dollar has strengthened while global equities have faltered. The reason: Investors are pulling back on risk, and the greenback has become more attractive as a safe haven. So have U.S. Treasury securities.

 

But renewed risk aversion would not be good for stocks in general, although consumer staples and utilities would fare better; for high-risk income vehicles, notably junk bonds; or for oil and industrial metals among commodities. Investments that are more economically sensitive and/or carry higher risk were hurt the most this week—and fared best today.

 

80 Years Later: What Now for the Dow?

 

Yesterday and today mark the anniversary of the biggest two-day decline in recorded U.S. stock market history. No, we're not talking about last year. It was 80 years ago: the two-day rout on Oct. 28-29, 1929 that sent the Dow Jones industrial average down 23 percent in just two days. Those two days, part of the so-called Great Crash, also saw the second and third biggest one-day declines ever.

 

Amazingly, the biggest single-day collapse was much worse than those two. The Dow plummeted 22.6 percent on Oct. 19, 1987, almost as much as on those two days in 1929. So the three biggest single-day declines, plus five of the top 10, have occurred in October.

 

After the 1929 crash of 35 percent, the Dow rebounded strongly and made up almost that entire decline by April 1930, only to roll over yet again. The crash of 2008-09 was worse in some ways, as the Dow tumbled 44 percent from just before the September collapse of Lehman Brothers to the March 2009 low. Since then, the market has mounted a powerful rally.

 

Let's hope that the next phase won't be a rerun of 1930.

 

The Treasury Bubble

 

Easy money breeds investment bubbles. There doesn't always have to be a bubble in the making, but if I had to pick the leading candidate now, it would be U.S. Treasury securities, no contest.

 

Several reasons have been advanced to explain the high prices of Treasury issues, resulting in incredibly low yields ranging from 0.95 percent for two-year T-notes to five-year notes paying 2.3 percent to 10-year issues at 3.4 percent. One explanation, of course, is the paltry yields on cash equivalents, such as money-market funds and banks savings accounts. And demand by foreign investors has been strong, despite the weak dollar.

 

 

 

Treasury securities offered refuge from the storm of 2008. But that was then. True, a new flight to safety could occur if another financial crisis hits. But we think the bigger risk now is that interest rates will rise sooner or faster than we currently expect. This could happen if the economic recovery gathers steam or if foreign investors hold off on buying the huge new supply of Treasury issues coming to market. This seems unlikely right now. But government issues, as the most rate-sensitive bonds, could be hard hit when it does occur.