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PRUDENTIAL SECURITIES, INC.
One New York Plaza, New York, New York
(August 11, 1997) STOCK INDICES: July was a tough act to follow, but so far, all the major stock indexes have continued on their record-setting ways. Last month, the stock market, as represented by the Dow Jones Industrials, posted a record monthly gain of 550 points. The bond market also did extremely well, with the yield on the 30-year Treasury falling to a 17-month low of 6.3% from 6.8%, motivated by the moderate-growth, non-inflationary scenario that has underpinned the equity market's advance. Although not quite a record, equity mutual funds took in $23 billion in July, up from $16.6 billion in June but short of January's all-time high intake of $29 billion. Bond mutual fund inflows almost doubled last month to $4 billion from June's $2.1 billion.
Ironically, the first day of August put July's ideal scenario to the test, as the Non-Farms Payroll report showed that 316,000 jobs were created in July, well above the 200,000 that had been expected. In addition, the unemployment rate dropped to 4.8% from 5% in June, matching the low set in May, which had been the lowest figure since November 1973. Moderating this strength were almost unchanged figures for the average work week and a slight rise in average hourly earnings. The real jolt came with news that the National Association of Purchasing Managers Survey rose to 58.6 in July from a reading of 55.7 in June, while the closely watched prices paid index rose as well. These unexpected shocks resulted in the largest one-day loss for the bond market in more than a year as the yield rose to 6.45% from 6.3%. However, after a Dow plunge of as much as 120 points during the session, the market's underlying strength reasserted itself to stage a 90-point rally that shaved the closing loss to “only” 30 points.
These rude shocks did not break the back of this ongoing bull market. Instead, every broad measure of stock performance–from the mighty Dow Industrials all the way down to the small-cap Russell 2000 Index–proceeded to attain all-time highs last week. This unrelenting strength was even more commendable because the bond market declined in four of the last five sessions, unable to regain its sea legs after the cataclysmic decline on August 1. Indeed, on three days last week, the “buy on the dip” mentality proved it was alive and well when the market was able to rally sharply from intraday losses. In addition to the 90-point rally off of last Friday's worst levels, the Dow turned an early, 60-point loss on Monday into a closing gain of 4 points. On Wednesday, an early 30-point loss turned into a 70-point closing gain to reach an all-time high of 8259.
The major economic event last week was the Treasury's quarterly refunding of $38 billion. Ironically, the bond market reacted most negatively to the third leg of the auction–for the 30-year bond–which turned out to be the most successful. That issue sold for an average yield of 6.445%, slightly better than market expectations; the three-year and 10-year note results of 6.041% and 6.205%, respectively, were only slightly worse than expected.
The economic numbers released this past week continued to show the slow-growth, non-existent inflation picture that the stock market has come to love and expect:
–June construction spending fell 1.1%, but the May number was revised upward.
–June home completions fell 7.8%.
–The June Index of Leading Economic Indicators was unchanged.
–The Johnson-Redbook survey of weekly chain store sales rose 0.3%.
–The Fed beige book of economic conditions around the country showed that the economy grew modestly in June and July. It also noted that prices for most goods were stable and being held in check by “competitive pressures.” Wage pressures were reported as “moderate,” although labor markets did tighten further. However, Federal Reserve Governor Susan Phillips remarked that inflation levels cannot get any better, and there is “risk” that they could pick up in the near term.
–Weekly jobless claims rose by 25,000 to 300,000 after falling to their lowest levels in more than 20 years during July.
–June business inventories rose 1.9%. which was the quickest pace in 15 years.
None other than President Clinton commented on the market's ongoing strength and the nearly ideal economic conditions that surround it. He said that the stock market gains of recent years were an “astonishing fact,” and that equities have gone up at “an unprecedented rate to unprecedented heights” (from Dow 3200 when he took office), accompanied by “very brisk growth in our economy and strong growth in productivity.”
One of the primary reasons for the incredible market gains of late have been earnings that continue to outpace expectations. As the second-quarter reporting period comes to a close (with 442 companies in the S&P 500 reporting results so far), 272 firms, or 61.3%, have exceeded expectations. Meanwhile, 74 firms, or 16.7%, have reported results that were in line; 97 firms, or 21.9%, have announced lower-than-expected results. Overall profits have exceeded expectations by 2.35% and have now gained 10.1% versus last year's second-quarter earnings. This figure compares to first-quarter 1997 profits of 15.2% and 11.3% gains for the fourth quarter of 1996.
Stocks whose earnings spurred them on to good gains last week included Cigna, Sony and Provident Insurance. On the other hand, Converse, Aeta, Newbridge Networks and United Health Care fell after reporting disappointing results. In addition, those second-tier stocks whose disappointing numbers lead to one-day massacres included: Lone Star Steakhouse, down 4, to 18; Wet Seal, down 8, to 18 (after a yearly high of 41); and Sitel, down 4½ to 10½.
The ongoing record pace of mergers and acquisitions continued last week with the shares of Sullivan Dental Products up 6 after being acquired by Henry Schein. In addition, QAD, Inc. rose 7½ points above its Initial Public Offering (IPO) price, to 22½, in its first day on the New York Stock Exchange.
For the five-day period under review, the Dow established a record close of 8259 while the S&P 500 closed at its best-ever level of 960.22 on August 6. However, a sell-off the next day left the indexes lower by 34 points and 3 points, respectively, for the period. In addition, the Nasdaq made six consecutive higher closes before ending lower on August 7. The Nasdaq gains were powered by phenomenal strength in the large-cap technology stocks such as Intel, Microsoft, Sun Microsystems and Dell Computer. Apple Computer roused the technology sector as it gained 8 points in two days after Microsoft announced that it will make a major investment in that company. Still, the biggest technology winner last week was the Semiconductor Index at the Philadelphia Stock Exchange. The index is up an astounding 66% for the year due to ongoing strength of such leaders as Intel, Applied Materials and Texas Instruments as well as long-dormant Micron Technology, which hit levels not seen in two years.
The Dow and the S&P 500 are up 27% and 28%, respectively, so far this year, which is absolutely phenomenal considering that they gained 33% in 1995 and 26% in 1996. The Dow is trading at more than 20 times trailing earnings and about 20 times projected 1997 earnings. These valuations can only be called into question if interest rates start rising (as they did last week) or if future corporate profits slow (early indications are that third-quarter gains are trailing those of the first half). Still, the combination of a strong dollar, increased productivity by Americr companies and global competition that is keeping inflation under control may be enough to prove we are in a new era where the old rules do no apply. Indeed, the yield on the S&P 500 has been at record lows for months, yet the market continues to defy the cynics who claim that these stock returns are not competitive with other investments.
We added on another bull put spread with the S&P options, buying the September 650 put and selling the September 755 put for a 25-point credit. This brings our total number of positions to five, including: (1) buying the August 680 put and selling the September 720 put for a 30-point credit; (2) buying the August 690 put and selling the September 725 put for a 25-point credit; (3) buying the August 675 put and selling the September 700 put for a 30-point credit, and (4) buying the August 660 put and selling the August 670 put at a 35-point credit. If the market can sustain itself at current levels or move higher, we will add other positions using different strikes as market conditions dictate.
Don Selkin
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Last updated on 08-15-97
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