wmeubank@ocp.kcmo.com
PRUDENTIAL SECURITIES, INC.
One New York Plaza, New York, New York
(March 24, 1997)
STOCK INDEXES:
Stocks and bonds finally came to terms last week with the idea that
it is almost a done deal that the Federal Reserve will raise interest
rates. As a result, stocks underwent a very significant internal deterioration
process in which declining issues were almost double advancing issues for
the first four days of the week. By week's end, the Dow lost 131 points
and the NASDAQ was down 11% from its January high. The bond market seemed
to come to terms with the inevitability of a rate increase by flattening
the yield curve as long-term rates rose more slowly than short-term rates.
The likelihood of higher interest rates kept markets volatile. The Dow
had a range of more than 100 points on Monday and Tuesday, backing off
only slightly to 80-point ranges the next two days and closing the week
(during a triple-witching session) with a relatively calm span of only
60 points. Warren Buffet, the second richest person in the country, fired
some rather heavy ammunition at the market early in the week, proclaiming
in his Berkshire Hathaway annual report that the stock market's rally over
the last two years has driven prices so high that investors are overpaying
for virtually all stocks in an overheated market. Obviously, this did
not sit too well as it came on the heels of similar jaw-boning by Fed Chairman
Alan Greenspan. Despite a very late comeback by the Dow the day Buffet
spoke, breadth numbers in the overall market were 2:1 in favor of losing
stocks.
Economic numbers were consistent with those of the last several weeks,
namely that they show the economy proceeding at a faster-than-expected
pace, but with no real signs of inflationary pressures surfacing yet:
"The National Association of Home Builders market index hit 58 in
March, up from 54 in February and the highest since July; it was a sign
of continued strength in the housing sector.
"February housing starts rose 12.2%, which was the largest increase
in three years.
"The Johnson-Redbook survey of weekly retail chain store sales
showed an increase Of 0.8%.
"The widely-anticipated Consumer Price Index for February showed an
increase of 0.3% (slightly higher than market expectations), and a core
rate increase (excluding food and energy) of 0.2%. "Real earnings
for Americans rose 2.4% in February, which was the largest monthly increase
in 15 years.
"The Philadelphia Fed Index of Business Activity for the mid-Atlantic
region increased to 21.1 in March from 17.4 in February.
"Weekly jobless claims rose only 3,000 to 312,000.
"The January U.S. trade deficit swelled 21% to $12.71 billion, the
highest level in nine years. Imports rose 2.2% while exports fell 0.6%.
These figures are largely a function of the stronger dollar, and could
cause first-quarter GDP to be revised downward. If there were any lingering
doubts concerning a rise in interest rates when the Fed meets this week
on Tuesday, Greenspan's testimony to the Joint Economic Committee of Congress
should have put them to rest. He proclaimed that the Fed must be preemptive
on inflation (translation: we will raise rates by 1/4 point before the
inflation genie ever gets out of the bottle) because recent data has shown
vigorous U.S. economic growth in early 1997. He also said that tight
labor markets are likely to pressure prices upward because labor demand
is strong. These remarks seemed to reinforce those made earlier in the
week by San Francisco Federal Reserve Bank President Robert Parry, who
stressed the need for the Fed to keep its credibility on inflation because
current risks seem to tilt to the building of inflation pressures because
the U.S. economy is doing surprisingly well.
Because the bond market accepted that rates would be rising, the yield
on the 30-year long bond hit 7%, but backed off modestly to the 6.96% level.
However, the flattening of the yield curve was the major change in the
credit markets as short-term yields rose, even while the long bond was
retreating from 7%. This occurred because the three- and six-month Treasury
bill rates are directly affected by Fed policy. Indeed, by week's end the
three-month T-bill was 5.25%, up from less than 5% just two weeks ago.
Although these yield changes would appear to indicate that the credit markets
have accepted the inevitability of a rate increase, it does not necessarily
mean long yields have to increase when the Fed officially raises rates.
That's because the long end of the market is concerned with the overall
prospects of inflation and economic growth.
Despite the week's volatile downward action, the hope is that any rate
increase is already discounted into current prices. In addition to the
steady stream of one-day destruction in secondary stocks (which have been
ongoing even as the major averages hit all-time highs), two market leaders"Phillip
Morris and Eastman Kodak"succumbed to large one-day drawdowns, as
well. The former fell 12 points in two days when the Liggett Group settled
with attorney generals in 22 states to label all of its cigarette packages
with a warning that smoking is addictive, in addition to stating its intention
to settle the ongoing litigation that all tobacco companies face. Kodak
dropped an astounding 10 points on Friday after the company made what was
construed as a negative earnings pre-announcement. These huge losses by
two prominent Dow members were certainly responsible for a good part of
the weekly decline.
We anticipate that any downside market reaction should not be too adverse,
and could ultimately be positive. We take this view because the internal
market structure for most measures of stocks has been deteriorating for
most of 1997, with the Dow Utility average, the NASDAQ and the Russell
2000 index of smaller stocks down for the year and the Mid-Cap index up
only nominally. Indeed, the NASDAQ 100 index, which consists of the 100
largest non-financial stocks (primarily technology) was down as much as
15% from its January high last week, before a slight recovery at week's
end. Although the generals and the troops have largely moved in opposite
directions for most of the year, the large losses by Phillip Morris and
Eastman Kodak last week indicate that even the generals are not immune
to setbacks. IBM, another general, has fallen over 35 points from its
high as well.
Despite the recent weakness, we still believe that stocks can maintain
current levels and possibly move irregularly higher this year, particularly
if the Fed does not become irrationally exuberant in raising rates. The
S&P 500 index is trading at a price/earnings multiple of 17 times this
year's projected earnings. and this ratio could only come into question
if interest rates rise consistently for the rest of the year. Earnings
grew about 11% in the fourth quarter of 1996 and are projected to rise
as much as 14% in 1997. Our bull put spreads with the March S&P options
expired worthless in our favor, and we will buy a lower April put this
week to maintain the short April 650 put on a spread. If the market can
sustain itself at current or higher levels. We will recommend additional
similar strategies but with higher strike prices. However, if the market
enters a more sustained decline, we will recommend a strategy of selling
the highest calls, in the 870-880 area, along with selling puts in the
mid-600 area.
Don Selkin
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