wmeubank@ocp.kcmo.com
PRUDENTIAL SECURITIES, INC.
One New York Plaza, New York, New York
(September 22, 1997) STOCK INDEXES: Although September is historically one of the worst months of the year for the stock market, it has proven to be quite positive for equities this year. The Dow started the month with its biggest point gain in history, up 257, on the month's first trading day. The continued ability of both the Dow and the S&P to hold at the lower end of their recent intra-day ranges (7600 and 895, respectively) means that the potential head-and-shoulders top formation that we spoke about in last week's issue, could very well be negated. Hence, these two market measures could continue in their broad trading range between 7600-8300 and 896-964 respectively. Indeed, based on recent market action, the bias within this trading range could now very well be to the upside.
The market's internal workings have undergone dramatic improvement–to the point of being quite bullish–even whites the Dow and the S&P 500 have faltered from last month's highs. This improvement is courtesy of other market measures that comprise stocks outside of the large-capitalization blue-chips, which have been attaining new all-time highs on almost a daily basis this month. Five indexes set all-time highs in each trading session last week in a demonstration of broader market strength, including: the Value Line Index (an unweighted measure of 1,700 stocks, both large and small); the Russell 2000 Index of small stocks; the Mid-Cap Index; the Dow Transportation Index; and the NASDAQ. That's not to say that the generals didn't march right along to the upside with the troops; The Dow ended the week with a gain of 174 points at 7917, while the S&P closed at 950, up 26 points.
The primary motivating upside force for stocks last week seemed to be a very strong bond market, as the yield on the 30-year Treasury issue fell as low as 6.35% before ending the week at 6.371%, its lowest level since early August. The bond market's strength came from a series of economic reports that continued to confirm the complete absence of inflationary pressures, even as the economy keeps moving at a fairly brisk pace:
–The August Consumer Price Index rose just 0.2%, while the core rate (excluding food and energy) inched up by 0.1%. This makes the 12-month annualized rate of 2.2% the lowest since 1966 and the 1997 annualized rate so far is only 1.6%, half the rate of inflation last year.
–August industrial production rose 0.7% and Capacity utilization rose 3.9%, which was the highest figure in two years.
–The Johnson-Redbook survey of weekly chain store sales fell by 0.5%.
–August housing starts fell by 4.8%.
–The Federal Reserve Beige Book of economic conditions was consistent with recent data showing steady economic growth and low inflation, and is further evidence that the Fed will most likely not do anything when it meets on September 30. The report mentioned that prices arc steady despite tight labor markets and that U.S. economic growth continues to expand. Most importantly, it pointed out that labor shortages are not causing general wage gains, and this has been evident in the benign inflation reports issued recently.
–The Philadelphia Fed Index fell to 20.4 in September from 24.3 in August, and the prices paid and received components fell as well.
–The July merchandise trade balance widened more than expected, to $ 10.3 billion, as imports rose to record levels while exports declined. This situation could weigh on economic growth in the future.
–Weekly jobless claims fell by 5,000 to 306,000, which was the lowest level in six weeks, and indicates the labor market's current tightness.
One factor that has led to bouts of market weakness for several weeks has been the issuance of negative pre-announcements by companies whose earnings will fall short of the mark during the upcoming round of quarterly results. This pre-announcement process takes place during the last month of the quarter and can produce sharp downdrafts for the companies involved. However, once the market gets through the bad news, it can be assumed that the news will be much better when the earnings reporting season for the third quarter gets underway in earnest during October. The preliminary consensus is for third- quarter earnings to increase by about 13%. Typically, about 300 companies release pre-announcements prior to the start of each quarter, and as of the middle of last week, 116 companies had done so. Of these, 59% expect earnings to come in below analysts' estimates. This percentage is in line with the normal level of negative pre-announcements, which typically account for about 62% of the companies announcing. Because nothing is out of the ordinary, it may explain why the overall market has not been adversely affected. Despite the preponderance of negative announcements, some companies benefited by better-than-expected earnings reports.
One of the driving forces behind the stock market's overall gains this year has been the amount of money coming into equity mutual funds. Despite an outflow of $788 million in the week before last as the Dow and S&P came down, the two days ending Monday, September 15 saw $3.9 billion come into these funds, with $1 billion earmarked for small-cap funds. September is on course for an incredible inflow of $41 billion, which would blow away the previous record of $28 billion act in January 1996 if it is realized.
Another factor that has helped the bull market is the record pace of mergers and acquisitions in 1997.
Despite last week's calmness (the Dow recorded just one triple-digit close, on Tuesday when it rallied 175 points), the Dow has changed by at least 1% on 29% of the trading days; last year, 1% moves occurred 17% of the time (matching the post-war average) and were just 7% of the trading days in 1995. Still, this year's volatility pales in comparison with the very bearish year of 1974, when the frequency of these moves took place an astounding 47% of the time, and the second most volatile year, 1987, when they occurred on 38% of the trading days. Today, a 1% move represents about 80 points in the Dow; in 1974, when the Dow was at 600, a 1% move equaled just 6 points. Given the higher level of outright prices, the price movements that we see today certainly appear to be more gut- wrenching, especially, when we remember how many times the Dow has either rallied or fallen 100 points in the last hour of trading.
Because of our belief that the Dow and S&P should be able to maintain the trading ranges outlined above for the near future (if not maintain an upward bias), we have entered into a bull put spread with the October S&P options: buying the 680 put and selling the 750 put at a 30-point credit. All of the September S&P option positions we held expired worthless in our favor, so we retained the premium captured at the trade's initiation. Assuming the market can sustain itself at current levels or higher, we will add other positions as conditions dictate.
Don Selkin
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