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PRUDENTIAL SECURITIES, INC.
One New York Plaza, New York, New York
(October 20, 1997) STOCK INDICES: The high hopes that favorable third-quarter earnings reports would lead the stock market into new all-time high ground were abruptly and decisively dashed last week as very negative market behavior took hold. Actually, it can be argued that the pessimism took hold two weeks before, when the bond market reacted to a very bullish non- farms payroll report on October 3 by rallying almost two full points and bringing the yield to as low as 6.17% on an intra-day basis, the lowest since February 1996. Naturally, stocks followed suit to the upside, with the Dow gaining more than 100 points that day. Then, in what was unfortunately a preview of last week's market action, both the bond and stock markets underwent abrupt downside turnarounds, erasing nearly all the gains to close about unchanged for the session. The supposed “reason” for this downside reversal was that a U,S. warship was sent toward the Persian Gulf due to Iranian violations of the no-fly zone over Iraq, which caused oil prices to surge. (Since then, that story has fallen off the radar screen and the dispute was settled last Friday.) The bad part about the market's reaction was that it revealed an inability to hold its gains on what was ostensibly very friendly news. In turn, the upside starts to become suspect, as the selling pressure at the higher levels has become too great for the buyers to overcome.
It was deja vu last week, when on Thursday, both the stock and bond markets succumbed to even more devastating downside reversals after what should have been bullish news–friendly Consumer Price Index and Philadelphia Fed reports. After strong early gains, with bonds up almost a full point and the Dow up more than 50 points, bonds sold off to end a half-point lower and the Dow fell more than 200 points from its high before ending with a closing loss of 119 points. On Friday morning, with a very negative bond market reaction to economic reports that were not that overwhelmingly negative, the Dow tanked to an intra-day loss of as much as 183 points before a late program-related rally cut the final figure to a loss of “only” 92 points. For the week, however, the Dow ended With a huge 198-point loss, and just when it appeared as if the stock market was about to “whistle past the graveyard” of the infamous crash of exactly 10 years ago, a bad confluence of circumstances did the market in. Once again, news with suspect staying power or influence brought the markets down. This time, it was reports that the U.S, Maritime Commission voted to order Japanese ships be denied entry at U.S. ports because Japanese shippers did not pay $4 million in fines in retaliation for what they consider discriminatory practices at Japanese ports. Supposedly, this move sparked fears of a trade war. Naturally, this supposed dispute also was resolved on Friday afternoon, with a deal worked out that would avert U.S. sanctions against Japan.
Even though “disappointing earnings” have been put forward as one of the reasons for the market's disastrous performance last week, 61% of the first 173 companies in the S&P 500 to have reported earnings, or 106 firms, have had positive surprises, or earnings above analyst's forecasts. Meanwhile, 29 firms, or 17%, matched expectations and 38 firms, or 22%, reported disappointing earnings. So why has the stock market tumbled? One could argue that good earnings already have been factored into stock prices, as in the case of Texas Instruments, General Motors and Merrill Lynch. In these three cases, prices rallied to all-time record highs just before the earnings reports were released and then proceeded to sell off after the numbers came out–a classic example of the old “buy on the rumor-sell on the news” syndrome, What's more, these sell-offs occurred even though each company reported earnings that were above expectations! Thus, it may be that the “good” news has already been factored into stock prices. Another reason behind the negative reactions to what would appear to be good news is that there may be anxiety that strong earnings growth has peaked and that earnings momentum may be starting to slow. Of course, proof of these two factors remains to be seen.
It was disturbing to see sell-offs in a large number of stocks whose earnings beat the estimates, perhaps for the reasons outlined here.
This type of market action, where good news goes largely unrecorded and bad news is punished severely, goes along with what has been taking place in the bond market, and is further evidence of a large change in market psychology. It appears that for the time being, the market is looking at the glass as being half-empty instead of half-full, as the marketplace has certainly taken on a bearish look.
The economic news released last week was mixed and did not appear to be of the variety that should have caused the bond market to sell off as severely as it did, with the yield on the 30-year Treasury issue climbing back to 6.44%.
–The Johnson-Redbook survey of weekly retail chain store sales was down 0.9%.
–September retail sales rose 0.3%, and the July and August figures were revised upward.
—The Atlanta Fed Index fell to 9 in September from 15.8 in August.
–The Consumer Price Index for September rose by 0.2%, as did the core rate excluding food and energy. Both of these numbers were below market expectations.
–The October Philadelphia Fed Index fell to 11.5 from 20.4 in September, and the new order and supplier delivery components fell as well.
–Weekly jobless claims rose 2,000.
–September housing starts rose by 7.9%, which was the largest increase in seven months, but the August number was revised downward to —5.1%.
–Industrial production rose by 0.7%, and capacity utilization increased to 84.4%, which was the highest since February 1995.
–The October University of Michigan consumer sentiment survey fell to 105.2 from 106 in September.
There was much posturing by various officials last week as they tried to explain what the economic numbers released so far mean and what the future might hold. Unfortunately, it all sounded like more of the same, and really leaves unanswered the question of whether the Fed will act to raise rates at the November meeting. Philadelphia Fed President Edward Boehne mentioned that years of economic growth have left little room for slack and that raises the risk that the economy may overheat, Therefore, the Fed must remain “vigilant” about the risks of an overheating economy, although the outlook for inflation through early 1998 remains favorable. Cleveland Fed President Jerry Jordan warned that “continued vigilance” is required for global economies to avoid financial instability, and stressed the need to achieve price stability. Atlanta Fed President Jack Guynn said that the Fed cannot lose the gains that have been made on the inflation front; he also noted that the U.S. economy is operating at a very high level of growth, Countering these veiled hints of an eventual Fed tightening was White House Chief Economic Adviser Janet Yellen who mentioned that U.S. inflation remains “well contained” and that there is “a lot of steam left” in the current economic expansion without any signs of “fragility” in the financial sector.
The one constant supportive factor that we saw last week was the ongoing record number of mergers and acquisitions this year.
Also potentially supportive for stocks was that inflows into mutual funds are running at a $17.2 billion pace for October. This is not quite the rate seen in September, with an intake of more than $20 billion, but it certainly is very strong.
Despite the market's poor showing last week, it has basically remained within its long-standing trading range of 7600- 8300 for the Dow. We expect this range should hold up, and perhaps the market can mount another assault on the highs. Some better earnings reports this week, especially from market giants IBM and Microsoft, could help with that assault. Our bull put spread with the October S&P options expired worthless our way last week, and we still hold the spread position of buying October 790 S&P puts and selling November 760 puts for a 35-point credit. We will add other positions as market conditions dictate.
Don Selkin
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