We have long felt that the only value of stock forecasters is to make fortune-tellers look good. – Warren Buffett
What had been manageable losses for the major stock averages unexpectedly turned ugly on Friday as stocks plunged, contributing to a painful decline of 6% for the week. It was the biggest weekly point drop for the Dow Jones Industrial Average and the S&P 500 Index since October 2008. Markets are driven by fear and greed and right now fear has the upper hand. Worries about a slowdown in global growth, particularly in China, intensified last week after a key Chinese manufacturing index fell to the lowest level in over six years and actually showed contraction, sparking fears that China’s economy was weakening. China also reported weaker retail sales and investment spending. This news came on the heels of the Chinese currency devaluation the week before and seemed to only add fuel to the fire. The release of the Federal Reserve minutes from its July meeting also seemed to unnerve investors as Fed officials thought that the economy met most conditions required to raise interest rates, presumably in September. But an increase in the federal funds rate now would only serve to strengthen the dollar which, when coupled with a weaker yuan, would have a negative impact on revenue growth and profits of U.S. multi-national companies. The release of the July Markit Flash purchasing managers index (PMI) on Friday only confirmed this as it fell, making the growth outlook murky due to the stronger dollar hurting exports. While economic growth in the U.S. should continue to be positive, there are worries that slower growth and even recession in emerging market economies could eventually wash up on our shores. If there is a positive to be taken from last week’s rout, it is that the Federal Reserve is not as likely to raise interest rates in September. By deferring a rate hike, the Fed would demonstrate much-needed patience and allow stability and a sense of calm to be restored to the stock market.
Economic data released last week certainly did not justify the carnage on Wall Street. Although the volatile and often unreliable Empire State manufacturing index was far worse than expected, the Philly Fed index was stronger than expected in July. Homebuilder confidence reached its highest level in nearly ten years and U.S. home sales surged and reached a fresh post-recession high in July. Jobless claims rose slightly but have now held below 300,000 for 24 straight weeks, a sign the labor market is strengthening. Leading economic indicators fell modestly but still point to moderate growth through year-end. The consumer price index (CPI) rose 0.1% in July and has risen only 0.2% over the past 12 months. Excluding food and energy, the core rate of inflation has risen 1.8% over the same time period, less than the Fed’s target rate of inflation of 2%.
Earnings reports last week were also mixed as Home Depot and Target beat estimates and raised their profit outlook while Lowe’s and Wal Mart missed analysts’ estimates and lowered their guidance. Outside the retail sector, Hewlett Packard and Deere reported weaker than expected earnings and issued disappointing outlooks for future earnings.
For the week, the Dow Jones Industrial Average sank 5.8% to close at 16,459 while the S&P 500 Index also lost 5.8% to close at 1,970. The Nasdaq Composite Index plunged 6.8% to close at 4,706.
Second quarter GDP is expected to be revised higher to 3.2% from the initial reading of 2.3%. After a strong June report that was boosted by aircraft orders, durable goods orders for July are forecast to fall modestly. New home sales in July should post a sizable increase as the housing sector continues to improve. The annual Jackson Hole Fed conference takes place this week and notably absent will be Fed Chair Janet Yellen.
Retailers will again be featured in this week’s earnings reports but they will be less prominent than those last week. Among those reporting include Best Buy, Dollar General, Tiffany, William-Sonoma and Abercrombie & Fitch.
Last week’s drubbing has left the S&P 500 Index down 7.5% from its all-time high of 2,130, only 2.5% away from what is usually defined as a correction or 10%. The stock market has not experienced a 10% correction in nearly four years and these losses put the S&P 500, Dow Jones Industrial Average and Russell 2000 (small cap) Index all in the red for the year. The S&P 500 Index now trades at 17 times earnings for 2015 and 16 times expected earnings for 2016, only modestly higher than the historical long-term average price earnings ratio. The S&P earnings yield, which is the inverse of the P/E ratio, is currently 6%, almost triple the 10-year Treasury yield of 2.05%. The S&P 500 dividend yield of 2.2% is now higher than the Treasury yield and stocks hold the prospect of higher dividends through growth in earnings. Before the plunge in stock prices on Friday, cash balances for managers were above 5% and are likely higher now, usually a situation that offers a contrarian buy signal. While no one can predict the near-term bottom in the stock market and it is tempting to cut and run, investors should review their investment objective and asset allocation and be comfortable with the level of risk in their portfolios. Despite the losses in the stock market last week, stocks still offer the best value among all of the asset classes as valuations are moderate, dividend yields are attractive and future growth potential exists. In the current low interest rate environment, these seem like compelling reasons to still own stocks.