Personal Finance Blog By MoneyRates

The stock market rallied to new highs in mid-May, as investors continued to ride the momentum from a surprisingly good jobs report that came out at the beginning of the month.

Investor sentiment has a great deal to do with how news is interpreted, and even reported. Not only have stock market bulls made the most of that recent jobs report, but they are now seizing on anything that can be interpreted as good news as another excuse to push stock prices higher. Unfortunately for more conservative investors in savings accounts and other deposits, banks will not be so quick to embrace this optimism by raising rates.

Bullish news

A widely reported indicator of stock market valuation reached a 58-year high recently. This indicator is the ratio of the earnings yield on stocks to the yield on Treasury bonds, and it is a good proxy for a of couple fundamentals that go into stock valuation, namely:

1. Prices relative to underlying earnings. Stock prices have gone up by a tremendous amount over the past several decades, but that doesn't mean that stocks keep getting more and more expensive. What matters from a fundamental investing standpoint is how much prices go up relative to the underlying earnings. So, everything else being equal, a stock selling at $20 a share with $2 a share in earnings should look the same to an investor as a stock selling at $40 a share with $4 a share in earnings. Both stocks would have a price-to-earnings (P/E) ratio of 10, and the earnings yield is simply the inverse of that P/E ratio.
2. The discounting value of interest rates. By comparing the earnings yield on stocks to bond yields, investors are acknowledging that interest rates discount the value of future earnings. The higher interest rates are, the less valuable future earnings appear. However, with interest rates as low as they are now, future earnings are not discounted by much, which makes stocks appear more valuable.

Because fundamental stock valuation is a function of prices, earnings and interest rates, stocks can be hitting new highs and still appear like a good value, as long as earnings have grown and/or interest rates are low.

The sobering facts

While the stock market is quick to celebrate any sign of good news these days, there are some more sobering facts about the current economy -- chiefly the fact that unemployment remains stubbornly high.

On the global front, it was recently announced that the European Union has entered its sixth quarter of recession -- with France now one of the countries in the union that is officially in recession.

The economy's lingering problems are the reason why depositors will have to wait a while longer for higher rates on savings accounts. The banking environment is closely linked to the grassroots of the American economy, and until economic improvement becomes more widespread reality than isolated stories, expect banks to keep rates on savings accounts and other deposits as low as possible.

One thing that has made the recent economy so challenging is its unpredictability. The latest twist was actually a positive one -- a surprisingly encouraging jobs report at a time when the economic recovery seemed to have lost momentum.

On March 3, the Bureau of Labor Statistics reported that 279,000 new jobs had been created, between the employment growth for April and upward revisions for previous months. Employment growth in April was responsible for 165,000 of those new jobs.

Upward momentum for jobs

While 165,000 is slightly below the monthly average of 169,000 for the past year, the number was encouraging because it exceeded expectations and represented a strong improvement over the original figure for March, which was just 88,000 new jobs.

That original March figure was revised upward by 50,000 in the latest report, and February's figure was revised upward by 64,000 new jobs. Add these revisions to April's job creation, and the total comes to over a quarter million new jobs in the latest report.

The stock market climbed to new highs within days of the job news, and the bond market also reacted to the renewed hopes for the economy. Bond yields jumped immediately on the employment news, and then continued to climb in the days that followed.

For bank customers, this could have a variety of long-term ramifications. It raises hopes for savings accounts because stronger economic growth should eventually mean higher interest rates. By the same token, the prospect of higher rates means that current mortgage rates may be a limited-time-only bargain for potential home buyers, as well as homeowners who want to refinance.

The economic road ahead

Is this the turning point that will see economic growth finally accelerate? Given that unpredictability has been the one true defining feature of this economic recovery, it is too early to say. However, it is not too early to prepare for what might happen if that's the case.

Stocks may continue to rise if growth strengthens further, but keep in mind that if interest rates start to rise, it will create a bit of a headwind for stocks. With the market having already rallied by 15 percent so far this year, it's biggest move may have come in anticipation of better news, leaving less potential for further gains should the economy actually improve.

Savings accounts should eventually see higher rates if bond yields continue to rise, but expect banks to lag behind the bond market at a cautious distance. Banks may be quicker to raise mortgage rates, since current mortgage rates are so low they represent a risk to banks if interest rates start rising.

Before any of this plays out, however, the economy will have to prove it can sustain this momentum. The next jobs report, due in early June, will be a key indicator. In the meantime, the latest news remains a positive twist rather than a definitive turning point.

New statistics on the real estate market show home prices have risen by about 9 percent over the past year. Does this mean that real estate is back?

On April 30, the Standard & Poors/Case-Shiller Home Price Indices release showed that a composite of real estate prices in 20 major metropolitan markets had increased by 9.3 percent over the past year, the best annual gain since May 2006. Does that mean the housing market is back to the heady days of the real estate boom? A quick reality check shows that not to be the case -- which may be good news for would-be home buyers.

A dose of reality

The first reality check is to look at how far home prices are still down from their peak levels. Despite the recent increase, home prices are still about 30 percent below the peak reached in the summer of 2006. Those prices have only recovered to the level first reached in the fall of 2003, meaning that homeowners on average have gone nearly a decade without seeing any increase in the value of their homes.

The second reality check is to recognize how much housing prices are dependent on current mortgage rates. Thirty-year fixed rate mortgages ended April at 3.40 percent. That means current mortgage rates are about 49 percent lower than they were when housing prices peaked in the summer of 2006, and about 43 percent lower than they were in the fall of 2003 when home prices were comparable to today's levels.

When you factor in those lower interest rates, people are paying far less for housing than they did at the peak of the real estate market, and even considerably less than they did when prices were at a similar level back in 2003. Take away the extraordinarily low level of current interest rates, and it is likely that the housing market would still be getting worse -- not better.

Winners and losers

Naturally, people who are in a position to buy a house in the near future are the winners in this situation. Despite some recent improvement, housing prices are still well below peak levels, and mortgage rates are at or near record lows. That adds up to greatly reduced costs for home buyers.

Less fortunate are people who bought their houses around the peak of the real estate boom. Property values are still well below what these homeowners paid, and as a result they may not have been able to take advantage of today's attractive refinance rates.

Also among the losers of the housing situation is anyone with a stake in the U.S. economy. Housing prices are widely followed as an indicator of the economy's health. Given the fact that record-low interest rates have so far fueled only a modest recovery in housing prices, the latest real estate news is hardly a sign of robust economic growth.

The price of a barrel of oil recently dipped below $90, which on the surface seems like good news for consumers and depositors in savings accounts. However, the context of the slide in oil prices is yet another example of the yin and yang nature of today's U.S. economy.

Just as yin and yang represent the good and the dark sides of life, the decline in oil prices over the past couple weeks has a kind of positive and negative duality. Cheaper oil prices are welcomed by most Americans, but what they say about the strength of the economy is troubling.

The dip in oil prices

Oil has had an up-and-down year so far in 2013. On a few occasions, the price of a barrel of oil has peaked at just over $97, only to slip back. Oil was up to that level again as recently as the first couple days of April, but by April 22 the price had fallen to $88.76, a low point for the year and a drop of about 9 percent.

Nobody who drives a car has to be told why lower oil prices are good news. Even away from the gasoline pump, lower oil prices benefit consumers in general because oil tends to set the tone for inflation in general. In particular, lower inflation -- or even a roll-back in prices -- would be a relief to people with savings accounts and other deposits, who have seen their purchasing power steadily eroded in recent years as bank rates have failed to keep up with inflation.

Broader context

The broader context for the decline in oil prices reveals the dark side of this news: Oil prices tend to fall when the economy is weakening, and economic news lately has been full of signs of weakness.

The latest example was the release of existing home sales figures on April 22. The National Association of Realtors (NAR) announced that completed sales of single-family homes declined by 0.6 percent in March. A recovery in real estate had been one of the economy's few consistent bright spots over the past year, so a cooling off in home sales is reason for pause. While the NAR dismissed the lower sales figure as being due to inventory constraints, the fact that the total inventory and the length of housing supply both increased in March suggests the drop-off may be due to weakening demand.

The bottom line for savings accounts

With the decline in oil prices representing both inflation relief and economic weakness, what's the bottom line for savings accounts?

Depositors might think of falling oil prices as the type of relief that addresses a symptom without curing the disease. In an era of low interest rates, keeping inflation down limits the damage done to the purchasing power of savings accounts. However, the real cure for depositors would be a return of interest rates to a more normal level, and that isn't likely to happen until the economy strengthens.

Inflation took a step back in March, which is news that should come as a relief to bank depositors in savings accounts and other interest-bearing instruments. However, there is a catch involved that prevents this from being completely good news for depositors.

Prices decline in March

On April 16, the Bureau of Labor Statistics announced that the Consumer Price Index (CPI) declined by 0.2 percent in March. This put to rest fears of a flare-up of inflation that had been stoked by the previous inflation report, which showed a 0.7 percent rise in the CPI during February. The decline in consumer prices during March left inflation at a moderate 1.5 percent over the past year, and running at an even milder pace over the past six months.

Once again, petroleum products were the key driver of inflation. In February, a 9.1 percent spike in gasoline prices had contributed heavily to the rise in the CPI. In March, a 4.4 percent drop in gasoline prices was the leading factor the CPI's decline.

Declining prices are a welcome break for bank depositors. With CD, savings, and money market rates generally running below 1 percent, virtually any inflation represents a loss of purchasing power for bank accounts. The catch is that the March decline in CPI was accompanied by signs of a slowing economy, and that is not good news for depositors.

Four scenarios and their impact on savings accounts

To better understand the trade off between falling prices and slowing growth, imagine a four-way grid that depicts the possible outcomes for both inflation and economic growth, with each ranging from high to low. The result would be four possible combinations, as described below:

1. Low inflation, slow growth. If this sounds familiar, it's because it has been the dominant environment of the past few years. In this scenario, inflation doesn't do too much damage, but savings accounts are not able to get ahead because slow growth keeps interest rates low.
2. High inflation, slow growth. This would be even worse for depositors, because while rising inflation might eventually push interest rates higher, a slow growth environment would likely mean that interest rates would rise more slowly than inflation, causing savings accounts to lose purchasing power more quickly.
3. High inflation, high growth. Under this scenario, both interest rates and prices could rise rapidly. Savings, money market and certificate of deposit rates would look healthier, but that would largely be an illusion because much of those higher rates would be eaten up by inflation.
4. Low inflation, high growth. This was the best-of-both-worlds environment that the U.S. enjoyed during the late 1990s. It would give interest rates a chance to get solidly ahead of inflation again.

The March CPI number suggests the U.S. is still in the first scenario. Depositors can count their blessings that it isn't the second one, but the ideal of the fourth one still seems a long way away.