The most important thing to do if you find yourself in a hole is to stop digging. – Warren Buffett
Despite a much weaker than expected employment report for September and mostly lackluster economic data last week, the S&P 500 Index managed to gain 1% as stocks staged a remarkable turnaround on Friday to close the day up 1.4% after being down 1.6%. The U.S. economy created only 142,000 new jobs last month, far less than the 210,000 that were forecast and the unemployment rate remained unchanged at 5.1%. To make matters worse, both the July and August non-farm payroll numbers were also revised lower and average hourly wages fell. During the last year, hourly wages have risen only 2.2%. While the jobless rate remained low, it was mainly due to a decline in the workforce and the lowest labor-force participation rate since 1977. After the jobs report was released, the stock market tumbled only to rebound with a furious rally as bad news turned out to be good news in the minds of investors. At least for moment, equities benefited from inaction on the part of the Federal Reserve to raise the federal funds rate. With the weak jobs data, investors figured that the Fed would keep their near-zero rate interest policy in place for the foreseeable future. This assumption convinced investors to pile into equities since they are viewed as the most attractive asset class. And who could blame them. The 10-year Treasury yield fell to 2.00% on the disappointing employment report and money market fund yields remain at practically zero. But this bullish sentiment could be short-lived as the third quarter earnings season begins this week. While most analysts are forecasting that revenues and earnings will trail year-ago results, expectations have been lowered, giving companies a better opportunity to beat estimates. Excluding the energy sector and accounting for the strength in the dollar, earnings are expected to grow only modestly.
Most of the economic data released last week was weaker than expected, adding to the anxiety among investors. Pending home sales fell in August due primarily to increasing home prices and a tight supply of homes. The September Institute of Supply Management (ISM) manufacturing index fell to the lowest level since May 2013, although it still registered a reading above 50, confirming continued expansion. August factory orders also dropped 1.7%, the largest decline in eight months. Jobless claims rose last week but even though companies are not hiring aggressively, they are not laying off a lot of workers, either. On the bright side, consumer confidence soared in September, easily beating projections and home prices rose 5% in July according to the S&P/Case-Shiller Home Price Index.
The head of the International Monetary Fund (IMF), Christine Lagarde, shared her concerns about slowing global growth, the prospect of higher interest rates in the U.S. and China’s slowdown, all of which she said are contributing to uncertainty and higher market volatility.
For the week, the Dow Jones Industrial Average rose 1% to close at 16,472 while the S&P 500 Index also gained 1% to close at 1,951. The Nasdaq Composite Index added 0.5% to close at 4,707.
Since the U.S. economy is mostly a service-based economy and not a manufacturing one, it will be interesting to see the results of the ISM non-manufacturing index for September, which will be released on Monday. The other economic data on the calendar this week are relatively insignificant and should not have an appreciable effect on the markets. The International Monetary Fund (IMF) will brief reporters on the world economic outlook and two Federal Reserve presidents will speak about the outlook for the economy.
Alcoa will split into two companies: one with the faster-growing aerospace and automobile parts business and the other with its bread and butter aluminum smelting business. Alcoa also unofficially kicks off the third quarter earnings season with its report scheduled on Thursday.
Other prominent companies due to report quarterly earnings include PepsiCo, Yum Brands, Monsanto and Constellation Brands.
While the recent correction in stock prices is definitely unnerving, there are reasons to believe that the decline will not turn into a bear market (a decline of 20% or more) similar to the bursting of the technology bubble in 2000 and the housing collapse in 2008. First, despite near-record high corporate profit margins that most certainly will come down, the S&P 500 Index has corrected (a decline of at least 10%) from its all-time high and stock valuations are reasonable when compared with historical averages. In addition, the yield on the S&P 500 Index is now higher than the yield on the 10-year Treasury, which is only 2.00%. Second, bear markets are usually caused by recessions and although the U.S. economy has slowed and is probably growing at a 2% to 2.5% pace, there is no evidence that a recession is on the horizon. Third, the last thing the Federal Reserve wants to do is prematurely raise interest rates and be responsible for sending the economy into a recession. It will remain accommodative as long as it is necessary to ensure that the economy is strong enough to handle higher rates. Fourth, the banking system in the U.S. is now much stronger than it was prior to the financial crisis and the Great Recession, thanks to higher capital requirements imposed by regulators and ample liquidity. Finally, lower interest rates have allowed consumers to refinance their debt and their finances are in better shape now than they have been in a long time. The plunge in energy prices should act like a tax cut and lead to increased consumer spending, which accounts for two-thirds of all economic activity.