Stocks weaker as volatility spikes and uncertainty lingers

It is fortunate for Wall Street as an institution that a small minority of people can trade successfully and that many others think they can. – Benjamin Graham

Although the S&P 500 Index ended the week with only modest losses, volatility returned with a vengeance as investors were taken on a roller coaster ride of highs and lows. The wild swings in the market were mostly the result of continued uncertainty over the effects of lower oil prices and lingering concerns over slowing economies overseas, particularly in Europe. The volume of shares traded was also low, which seemed to exaggerate the moves both up and down. Investors are still having a difficult time deciding whether or not low oil prices will benefit or hinder stock prices. Stocks followed the drop in oil prices early in the week but rebounded later in the week when oil prices rose and stabilized. Low oil prices are also contributing to deflationary fears, especially in Europe, where economies are teetering on the brink of recession and badly in need of additional stimulus measures to reignite economic growth. Worries that the European Central Bank (ECB) will not implement a comprehensive quantitative easing program at its meeting on January 22nd is a major concern on the part of investors. A threat by Greece to exit the European Union also could prove problematic and lead to unwanted political and financial consequences. At home, the December employment report released on Friday seemed strong at first glance with over 250,000 jobs created and a drop in the unemployment rate to 5.6%. But a closer look beneath the surface revealed that wages for the month fell by five cents an hour, dragging the annualized wage gain down to 1.7%. If this lack of wage growth continues, it could indicate that there is more slack in the labor market than the headline numbers suggest, which would allow the Federal Reserve to postpone any interest rate hikes even longer. This belief, coupled with global growth concerns and low oil prices, was reflected in the price action of the 10-year Treasury, which ended the week with a yield of only 1.97%. While it is still early, for the second straight year in January, bonds have rallied and interest rates have declined even as consensus forecasts have called for just the opposite to happen.

Last Week

Both the December ISM non-manufacturing index and the November factory orders were weaker than expected, indicating that the pace of U.S. economic growth probably slowed somewhat in the fourth quarter. The ISM reading was the slowest rate since February, but still showed expansion while factory orders were down for the fourth straight month. Wholesale inventories, on the other hand, rose 0.8% in November, beating estimates and a positive sign for growth.

Other data on the labor market were also fairly strong last week. For the 16^th time in 17 weeks, the number of weekly jobless claims stayed below 300,000 and the ADP private sector jobs report showed the creation of 241,000 jobs. In addition to the better-than-expected increase of 252,000 new jobs in December, the two prior months of October and November were revised higher by 50,000 jobs. Not since 1999 has the U.S. economy created this many jobs, an average of over 240,000 jobs a month last year.

For the week, the Dow Jones Industrial Average lost 0.5% to close at 17,737 while the S&P 500 Index fell 0.7% to close at 2,044. The Nasdaq Composite Index declined 0.5% to close at 4,704.

This Week

The highlight of this week’s economic calendar is retail sales for December, which are expected to increase only 0.1% on lower automobile sales and fewer gas station receipts. Both the December producer price index (PPI) and consumer price index (CPI) are forecast to drop on much lower gasoline prices, although their core rates, which exclude the volatile food and energy components, are expected to remain stable.

Alcoa will kick off the fourth quarter earnings season and will be followed by a plethora of both money center and regional banks, including JP Morgan Chase, Citigroup, Bank of America, Wells Fargo, Goldman Sachs, SunTrust Banks, Comerica, MB Financial and Wintrust Financial. Intel and Schlumberger are also scheduled to report earnings.

Portfolio Strategy

With U.S. economic growth accelerating and the employment picture brightening with each jobs report, one could conclude that interest rates should be on the rise, especially when the Federal Reserve is widely expected to raise rates at mid-year. Not only has the yield on the 10-year Treasury surprised on the downside, but the 30-year Treasury yield has reached 2.54%, a level not seen in almost three years. Usually the long bond has been a reliable indicator of longer-term growth prospects and inflation expectations in the economy. What is causing interest rates to move lower is a slumping European economy and cascading energy prices and the fear that economic weakness overseas could eventually find its way to the U.S. Earlier in the week as Treasury yields fell, the yield on the 10-year German Bund reached 0.46%, an all-time low. The seemingly strong employment report only muddied the waters further. Such strong job growth that allowed the unemployment rate to fall to only 5.6% should lead to tighter labor markets and push wages higher. The fact that wages actually dropped slightly could mean that the economy is weaker than first thought and that inflation could be kept under the Fed’s target of 2% for an extended time. The most recent Federal Reserve minutes released last week shows that the Fed acknowledges the weakness in Europe and the potential for deflation. For these reasons, the Fed should tread lightly and be patient on raising interest rates until it sees clear signs that the economy is on solid footing.