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PRUDENTIAL SECURITIES, INC.
One New York Plaza, New York, New York
(November 3, 1997) STOCK INDICES: Just one short month ago, you would have expected the stock market to be catapulting to all-time highs if you had been told that over the course of October the following conditions would exist: (1) the 30- year bond yield was at its lowest level of the year, 6.15%; (2) the implicit price deflator for third-quarter GDP rose by a scant 1.4%, its smallest gain in 33 years; and (3) of 432 companies in the S&P 500, 57% of them had beaten analysts' estimates by an average of 1.12% over the projected 11.25% profit gains over the previous year. Instead, October ended with one of the most gut-wrenching weeks in the history of the stock market, and a loss for the month of 7.7%. First, the Dow Jones Industrial Average registered a record one-day point loss, then followed that dubious accomplishment with a record one-day gain. For the final three days of last week, the Dow thrashed about in volatile trading conditions; four of the five days produced record trading volume. And if that wasn't enough for one week, we also saw the first-ever implementation of the entire gamut of trading halts. When the Dow fell 554 points on Monday, it tripped the ultimate circuit breaker of 550 points and brought trading to an end about 40 minutes before the normal closing time on the New York Stock Exchange.
What were the reasons for this historic plunge and ongoing investor skittishness? It certainly was not any disapproval of the U.S. economy, as the fundamental backdrop in this country remains as good as could be, with virtually nonexistent inflation (evidenced by gold's drop to 12-year lows last week), better-than-expected earnings growth and a friendly interest rate structure. Bizarre as it may seem, the U.S. stock market caught a bad case of the “Asian flu,<160> as severe downdraft in the Hong Kong market that began October 23 sent our market reeling. As each day dawned last week, the obsession with what happened in the Far East determined whether or not the U.S. market would fall or rise. The Hang Seng's plunge of 13.7% in one day corresponded with our largest one-day Dow point loss ever; Hong Kong's one-day rally of 18% led to our record one-day gain of 337 Dow points.
This linkage reached absurd heights late Thursday, when the December S&P futures traded 13 points lower in the late afternoon after-market in the United States in anticipation of further losses in Hong Kong on Friday. After realizing those losses, the Hang Seng staged an intra-day turnaround that resulted in a closing gain. Presto! The December S&P contract made a huge upside gap on Friday's opening. To gain some perspective on Hong Kong's 38% plunge over the last two months, remember that the market there soared 480% from late 1990 to its early September peak this year; the Dow rose “only” 250% at its peak over that same time. Also, the United States exports only 2.4% of its GDP to Hong Kong and only 1% of our imports come from there, which means that a minuscule 0.25% of affected by any slowdown in the Hong Kong economy.
In addition to the Far East, the U.S, market received another jolt from abroad on Thursday when the Brazilian stock market plunged 9.8% due to some supposed talk of credit downgraded of banks in that country, which has not yet materialized.
The primary issue facing U.S. markets appears to be how much economic growth will slow because of the volatility overseas. It would appear that economic growth in America will ease somewhat because of financial turmoil across Southeast Asia. Ironically, this follows a period in which many thought that out economy was overheating (evidenced by large, intermittent bond market sell-offs in recent months), which raised fears of possible interest rate hikes by the Federal Reserve at its November or December meetings. Now that world events have raised concerns about U.S. economic growth potential, we believe the Fed's hands are tied and it will not raise rates. It appears that the gyrations in the U.S. equity markets are attempts to find a level where any future potential earnings slowdowns will be discounted. This is why the most volatile fluctuations have taken place in stocks that ostensibly have the greatest exposure to overseas turmoil, such as technology and banking issues.
The economic numbers released last week were certainly overshadowed by the foreign turmoil, and on the whole, they should have been comforting for the bond market, which in turn should have been supportive for stocks. Instead, we saw continuation of the inverse relationship between bonds and stocks that has developed over the last two weeks. In the so-called “flight-to-safety” in U.S. Treasury issues, bonds rally and stocks fall, and vice versa. Last week's examples of this phenomenon included strong bond rallies while the stock market registered large losses and a sharp bond market sell-off on Tuesday, the day the Dow set its record one-day point gain. It is absolutely mind-boggling to watch the intra-day action and see these two markets diverge, a situation that completely goes against the time-tested idea that lower interest rates are supportive to equity prices, Here's how last week's economic numbers came in:
–September existing home sales rose by 0.2%.
–The second-quarter employment cost index rose by 0.8%, in line with estimates.
–The Johnson-Redbook survey of weekly chain stores sales rose by 0.6%.
–October consumer confidence fell to 123.3 from an upwardly revised 130.2 in September.
–September durable goods orders fell by 0.6%.
–Weekly jobless claims fell by 16,000 to 297,000, which dropped the four-week moving average to 305,200, the third lowest of the year, all of which underscores the ongoing tight labor market.
–New home sales for September fell by 0.2%.
–The preliminary estimate for third-quarter GDP rose by 3.5%, with a 1.4% price deflator, which was the lowest since 1964. Consumer spending rose by 5.7%, the largest increase in five years.
–The University of Michigan consumer sentiment index fell slightly to 109.5 in October.
–The Chicago Purchasing Managers survey fell to 56 in October from 61.2 in September, but the prices paid component rose.
–The Federal Reserve Beige Book report on economic conditions in various regions of the country saw “few reports of wage or price pressures” despite more tightness in the labor markets. It also said that manufacturing activity accelerated or remained high and that retail sales were mixed.
Normally, the major economic event of the last week would have been the testimony of Fed Chairman Alan Greenspan before the Joint Economic Committee in Congress. But, overseas events limited the potential impact of what he could say, and they definitely took away his ability to give harsh warnings of the type that had rattled markets previously. What he could say was that the recent drop in the stock market should prolong the economic expansion, and that inflation was low and falling, He mentioned that the Asian turmoil is unlikely to threaten U.S. prosperity, and that “it is quite conceivable that a few years hence we will look back at this episode (the biggest one-day point loss in market history), as we now look back at the 1987 crash, as a `salutary event' in terms of its implications for the macroeconomy.” He concluded by saying that earnings expectations and equity prices were “primed to adjust” in light of the Southeast Asian crisis.
It is ironic to note that for several weeks, we had seen an increase in “tough talk” from various Fed officials about the need to be “preemptive” against an accelerating economy in order to keep inflation contained. However, worldwide events of the last few weeks have deflationary implications, as devalued Asian currencies will result in lower-priced products being exported to U.S. shores. So, instead of the stern warnings of recent weeks, we got “soothing” comments from the Fed last week in light of market conditions, including the following:
–Kansas City Fed President Thomas Hoeing said that (1) U.S. inflation was “moderate;” (2) rising wages are not an “automatic” inflation trigger; (3) CPI and PPI readings show that inflation is not a threat “at the moment;” (4) the strong U.S, Dollar should help curb inflation near term; and (5) recent capacity utilization figures are not at historic peaks.
–Chicago Fed President Michael Moskow said that the Fed aims are to make sure the economic expansion continues and to keep inflation low. He added that the U.S. inflation rate is remarkably low despite very strong growth and a falling jobless rate.
–St. Louis Fed President Thomas Melzer said that the U.S. economy is doing exceptionally well this year, with low inflation and strong employment, and suggested that this scenario should continue.
–Boston Fed President Cathy Minehan said that the basics of the U.S. economy continue to be “positive” while price pressures continue tame. Job growth and personal income are strong, and these are the primary drivers of consumption.
–Fed Vice-Chairwoman Alice Rivlin said that last week's drop in U.S. stocks has had a small restraining effect on the economy but that the overall picture had not changed drastically.
A senior Treasury Department official told private-sector advisors that the U.S. economy is on a steady, low-inflation track after the pace of expansion slowed near the end of the third quarter. As nearly as Treasury officials can tell, our economy seems likely to maintain a moderate pace of growth in the foreseeable future while inflation remains relatively low and stable.
Finally, the “heavy artillery” came out in reaction to the record one-day Dow plunge. Chinese President Jiang Zemin said on Tuesday he was “confident” about the Hong Kong market, and President Clinton said that the U.S. economy was “strong and secure.”
The ongoing record pace of mergers and acquisitions continued last week, albeit at a slower pace than previous weeks.
The earnings season is winding down, and the late results were overwhelmed by the unprecedented market volatility.
As one would expect, U.S. equity mutual funds suffered a net outflow of $1.32 billion last week, which compares with a net inflow of $5.7 billion the prior week. In September mutual funds recorded an intake of $25.8 billion, which was the third highest level of the year, an 85% increase over August (also a very volatile month) and a 49% gain over September 1996. So, it appears as if the money is there, waiting to go into the market if conditions warrant it, This attitude is very important, as money flows into mutual funds have been one of the big underpinnings of the bull market of recent years.
Earnings have been coming in just fine. Of the 432 companies in the S&P 500 that have reported so far, 247 firms (57%) have beaten analysts' expectations, 86 firms (20%) have come in on target and 99 firms (23%) have fallen below estimates, On the whole, earnings have been 1.12% better than the originally projected gain of 11.25%.
Last week's market action was of the ultimate white-knuckle variety. Monday's record Dow loss of 554 points was “only” 7.2%, the twelfth largest on record; in October 1987, the “crash” equaled a loss of 22.6% in one day. On Tuesday, the Dow immediately fell 190 points early, as carryover panic liquidation entered into the market in the first hour. But, the Dow halted at 6971, just short of the measured move downside objective of 6900 taken from a head- and-shoulders formation; a subsequent 530-point rally carried the Dow to a closing gain of 337 points, its largest one-day advance, In percentage terms, the 4.7% gain ranked well below many that have exceeded 9%. (However, most of these large percentage gains took place in the 1930's, when the Dow was only in double-digits.) Tuesday had the distinction of posting record volume at an almost hard-to-fathom 1.2 billion shares. Wednesday saw an early gain of 120 points carry right back to the “neckline” resistance of 7600, which sent the market back to a closing gain of only 8 points. During the trading day, the upside 50-point program-trading limitation had to be invoked four times (a record) as upside thrusts greater than this amount were continually turned back and then attempted again before ultimately failing. The downdraft continued on Thursday, with an early loss of 100 points followed by a brief mid-day rally that produced a gain of 35 points; a late sell-off ended with a 125-point closing loss. Friday saw another attempted rebound, with an early gain of 115 points, followed by a sell-off to a brief loss of 30 points, before recouping to end with a closing gain of 60 points. Aside from Monday's bloodbath, it was disturbing that the market was unable to hold its best gains of Wednesday, Thursday and Friday. This action shows that the market it not out of the woods yet, as sellers come in to thwart rallies at these higher levels.
The head-and-shoulders top formation that we have been writing about since August finally materialized last week. The left shoulder was formed by the Dow consolidation between 7600 and 7800 in June and early July. The head was formed by the market top at 8300 in early August, while the right shoulder was formed by action that kept the Dow above 7600 from mid-August until last week. When the 7600 level was pierced decisively to the downside on Monday, a “measured move” objective of 6900 was the target. The target was determined by subtracting the distance from the neckline to the head (8300-7600, or 700 points) from the broken neckline (7600-700 = 6900). We now must assume that the market will carve out a lower trading range between support at the recent lows and resistance at the neckline of 7600. Only a decisive break above the 7600 level would set the market up for another challenge of the 8000 level and above. Considering the technical damage that has been done, this assault probably will take a long time, especially considering that so many large- capitalized stocks (which are the main components of these indexes) are well off their highs due to potentially lowered earnings growth rates.
We hold one position with the S&P options: long the November 690 put and short the November 760 put. Even though these strikes remain well below the market, option premiums have exploded to the upside due to last week's volatility. So, it appears we will have plenty of time to enter into additional positions in the remaining three weeks of the November series, and we will closely monitor market action before making additional recommendations.
Don Selkin
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