David Joy: Investors keep hanging on as stocks inch higher

The U.S. economy has already passed the first round of tests regarding second quarter activity. Now comes the second round.

We have previously learned that job creation, manufacturing and service activity, and vehicle sales in April were all quite strong. This week we will find out whether retail sales, industrial production, housing starts and building permits, and consumer confidence enjoyed a similar rebound.

First quarter earnings have been better than expected, but not robust. For full year forecasts of earnings growth to be achieved, economic activity has to accelerate. The early returns look promising, but there is a long way to go before we can put the first quarter firmly in the rear view mirror.

Investors seem to be coming around to the interpretation that this scenario may be playing out. In early trading on Monday, the S&P 500 surged to a new all-time high. Whether new highs can be sustained remains to be seen.

But if the economy does, indeed, shake off the weather effects of the first quarter, and the conflict in Ukraine stays relatively well contained, then the prospects for higher earnings become more tangible, as does the possibility higher stock prices.

To its credit, the broader averages have held up relatively well in the face of the washout in high flying social media and biotech shares. This may be a testament to the underlying, but unexpressed, view that the outlook for the economy and stocks is generally favorable. Investors have simply wanted to see empirical evidence that such a view is justified. The economy is perhaps now beginning to provide that evidence.

Another possible explanation why stocks have held up relatively well may be a recognition that so-called momentum stocks function in a universe of their own, divorced from valuation fundamentals, and responding more to Newton’s Laws of Motion. As long as buyers continue to jump on the bandwagon, these stock prices are pushed higher and higher, until those buyers begin to sell, and the process reverses.

This process has little to do with economic or company-specific fundamentals, but rather the belief, self-delusional or not, that a rising stock price is likely to continue to rise. The trick is to jump off the bandwagon before everyone else. That both the Dow and now the S&P 500 are pushing toward new highs, while momentum stocks are falling back to earth, is a potentially encouraging sign that investors are discriminating between short-term trading strategies and fundamental investing.

The economic calendar this week also contains the latest readings on the inflation front. Both producer and consumer prices are expected to have risen once again in April after having jumped higher in March. There is little fear that prices are about to accelerate to the upside. Wage gains, for example, remain subdued.

But, there is also a growing suspicion that the best news on inflation may be behind us. Home prices are still rising. Food prices are as well, in part because of drought conditions in the West. The Dow Jones UBS Commodity index is now 11% above its early January low. The yield on the ten-year Treasury note had been languishing at or below the 2.60% level for the past few weeks, but has crept higher in the past few sessions to 2.65%. On the other hand, the two-year note has exhibited little concern for rising prices, as its yield has remained below 0.40%. But if the two inflation gauges rise as expected, bond yields could move higher, especially if the other economic data reinforces the view that activity is firming.

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