Just as a cautious businessman avoids investing all his capital in one concern, so wisdom would probably admonish us also not to anticipate all our happiness from one quarter alone. – Sigmund Freud
The fact that the S&P 500 Index closed modestly lower for the fourth consecutive week does not tell the whole story as turbulence and volatility again gripped the market. As investors worried about the potential spread of Ebola and slowing global economic growth, the S&P 500 Index plummeted on Wednesday to 1,820, a level that was 9.5% lower than the all-time closing high and dangerously close to the 10% decline that typically defines a correction. Although the stock market climbed back from the abyss to end the day with only minor losses, the roller coaster ride left investors gasping for air and testing their nerves. The panic-like selling in stocks also affected the Treasury market as investors piled into government bonds, sending bond prices soaring and yields plunging. The yield on the 10-year Treasury actually dropped to 1.87% before ending the week at a more reasonable level of 2.22%. While the mid-week downdraft in stock prices had all the earmarks of capitulation by investors and a sign that the worst is over, it may be too soon to give the all-clear signal. As long as fears about the spread of Ebola are front-page news and concerns about slowing global economic growth continue to increase, the stock market is likely to remain volatile in the weeks to come. Although third quarter corporate earnings reports have been strong so far and recent U.S. economic data has mostly been favorable, these positives have largely been ignored as Ebola and deflationary fears grab the headlines. In the meantime, the stock market will once again have to climb a wall of worry until these fears subside and the focus turns to what really matters – fundamentals and earnings.
Wholesale prices fell 0.1% in September due primarily to the drop in gasoline prices and producer prices have now risen only 1.6% for the year. Retail sales declined last month for the first time in eight months on fewer automobile purchases and lower gasoline prices. Industrial production was better than expected in September as there was a big increase in utilities output and housing starts rose with the construction of more apartment buildings. Jobless claims fell to the lowest level in 14 years as the labor market continues to improve. While U.S. small business confidence fell in September, a measure of consumer sentiment rose to its highest level since July 2007.
For the week, the Dow Jones Industrial Average skidded 1% to close at 16,380 while the S&P 500 Index also lost 1% to close at 1,886. The Nasdaq Composite Index fell 0.4% to close at 4,258. In a good sign for small cap stocks, the Russell 2000 Index bucked the downward trend and closed up 2.8%.
Economic data will again take a back seat to third quarter earnings reports this week as the calendar is light. Both existing home sales and new home sales for September should be indicative of a healthy and improving housing sector. Leading economic indicators for last month should also reflect a moderately growing economy in the 2% to 3% range. The September consumer price index (CPI) is expected to show an increase over the prior month but still confirm that inflation is well under control.
Estimates for China’s third quarter GDP growth will be released and expectations are for growth to slow modestly but still exceed 7% on an annual basis.
Earnings season swings into high gear this week as a number of notable companies are scheduled to report. Among the largest and most familiar include IBM, Apple and Microsoft in the technology sector, Procter & Gamble, McDonalds and Coca Cola in the consumer sector, Abbott Labs and Bristol Myers Squibb in the health care sector, AT&T and Verizon in the telephone utilities sector and Boeing, 3M, Ford and GM in the capital equipment sector.
While there are a number of potential threats to the U.S. economy that could derail the stock market, it’s important to step back and evaluate the likelihood of each one. First of all, the transmission of Ebola is difficult and makes it highly unlikely that it won’t be contained soon. Secondly, although weak economic growth in Europe is sparking deflation fears, the decline in the euro currency is providing a huge tailwind for companies that export their goods overseas. The end of quantitative easing this month has also worried investors but the Fed has said time and time again that interest rates will remain low for a “considerable time” and that any change in rates will be “data dependent”. The strength of the U.S. economic recovery has also been called into question, but most economists are forecasting growth of between 2% and 3% both this year and next. No one is forecasting a recession, which inevitably leads to a bear market. A strong dollar and falling oil prices are raising concerns, too, but the former will result in lower overseas expenses for companies while the ladder will certainly benefit consumers in the same way a tax cut would. Although the stock market has not officially corrected by 10%, it did drop by 9.5% from its closing high in September. Volatility will likely continue but there is no evidence that a drop of 20%, defined as a bear market, will happen. At current levels, the S&P 500 Index now trades at just 14 times forward earnings estimates, which is slightly below the historical average and certainly not overvalued. If investors begin to focus on the strength of third quarter earnings, they may regret not taking advantage of this correction in stock prices.