David Rosenberg: This equity market rally may have some legs

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Maybe I sold this rally short – valuation and earnings concerns are at play but other stabilizing developments have taken over.

China's economic data have improved, even if credit-induced.

The U.S. dollar has stopped making new highs.

Oil has managed to consolidate around the $40 (U.S.) a barrel level.

The technical picture has improved – breadth in particular, as 90 per cent of stocks are north of their 200-day moving averages. In stark contrast to the September and November bounces of last year, all of a sudden this rally is seeing broader participation. The Nasdaq rose 1.8 per cent last week and reclaimed its 200-day trend-line.

While the major averages are still shy of their highs, the NYSE cumulative advance-decline line just broke above its own.

Financials are starting to outperform as the banks posted better-than-expected earnings results last week.

And sentiment remains depressed, which is a contrary positive as evidenced by investors yanking $6-billion from developed markets last week – Japan saw its largest net withdrawal in two years and European funds saw a $2-billion outflow (the 10th consecutive outflow) and the United States suffered a $1.3-billion net redemption.

The high-yield corporate bond market is flashing the green light for risk appetite as well, confirming the stock market's message. As the Current Yield column points out in Barron's, the "fallen angels" (bonds that slipped from Investment-Grade to junk) have generated a 9.3 per cent net positive return this year (more than 5 per cent now for the overall High-Yield market).

And the Treasury market is signalling no interest rate risk as investors easily digested $56-billion of new notes and bonds auctioned last week – the 10-year T-note yield closed the week down four basis points to 1.75 per cent (soothing words by prior hawk Dennis Lockhart from the Atlanta Fed didn't hurt, either).

To be sure, the data flow has been less than stellar. Industrial production sank 0.6 per cent month-over-month in March, and February was marked down to minus 0.6 per cent as well from minus 0.5 per cent.

Even without the weather-induced plunge in utilities, output fell with manufacturing slipping 0.3 per cent month-over-month on top of a 0.1 per cent dip in February, and the declines broad-based even if dominated by the auto sector.

The lone bright spot was that the production of high-tech equipment rose 0.5 per cent, the fourth increase in as many months and six of the past seven.

Consumer sentiment as per the University of Michigan index was equally downbeat as the index fell to 89.7 in the flash April reading from 91 in March – the fourth consecutive decline to a seven-month low.

But the numbers for the most part are backward-looking while the markets are forward-looking.

The first quarter was still held back by the dollar, oil and bloated inventories. All three constraints seem to have been lifted as the broad array of March survey data attest.

One item that may have investors seeing a parting of the clouds is the ECRI leading economic indicator – it rose one point last week to 134.2 and this was the seventh increase in a row to the highest level in 11 months. The smoothed index also advanced for the sixth straight month to a 2.5 per cent annual rate, its best momentum in well over a year.

As well, the April reading of the New York Fed's Empire State manufacturing index improved to a 15-month high of 9.56 from 0.62, with the ISM-adjusted measure rising to a 13-month high of 51.9 from 51.1 and 43.0 as recently as January.

All of the forward-looking components showed forward momentum, which is great news for a second-quarter rebound in growth – orders, backlogs and vendor performance.

The six-month outlook firmed to 29.4 from 25.52 in March, ‎14.48 in February and the 9.51 nearby low posted in February. Capex plans jumped to 22.13 from 15.84 and now at the best level in a year. Tech spending intentions soared from 9.9 to 21.15 and this index has not been this high since March 2012.

And it was interesting to see that within the University of Michigan consumer confidence headline, auto buying plans rose to 146 from 145; buying conditions for big ticket household goods inched ahead to 156 from 155. Consumer expectations for business conditions a year out rose to 102 from 100 in March and 97 in February. So the forward-looking stuff looked good beneath the surface.

What seems to have bugged the marginal household in April was less about the economy and more about politics as the index assessing government policy dropped four points to 77 – only 19 per cent of those polled believe the government is doing a good job, while 42 per cent think it is doing a poor job.

Finally, a word on the bond market, which has held up remarkably well of late despite the rebound in risk assets and commodity prices. The 10-year U.S. Treasury note yield cannot seem to break above 2 per cent – a level that entices a boatload of buying activity. The fundamentals are pretty good, even with the U.S. economy showing some verve as it exits what looks to be dismal first-quarter GDP reading.

The five-to-10-year median consumer inflation expectation measure (as per the University of Michigan survey) receded to 2.5 per cent in April from 2.7 per cent in March and tied for the lowest level of the past three decades. And with good reason.

The industrial production report showed capacity utilization rates dropping to a noninflationary 74.8 per cent in March from 75.3 per cent in February and 75.8 per cent in January – now fully five points below the long-run mean even as the economic cycle becomes that much more mature at nearly seven years (and of the Four Horsemen that determine recessions and expansions, only industrial production is off its highs – real business sales, real personal incomes excluding transfers and employment are all at peak levels with decent momentum).

The New York Fed's Empire State manufacturing outlook survey, while constructive for real economic activity, showed pricing power in retreat in April as the six-month prices-received outlook subcomponent dipped to 5.77 from 7.92.

And back to that University of Michigan poll – even as inflation expectations came down, only 6 per cent of those polled see potential for yields to fall any further while 66 per cent are bond bearish. A contrarian's dream.

David Rosenberg is chief economist with Gluskin Sheff + Associates Inc. and author of the daily economic newsletter Breakfast with Dave.