wmeubank@ocp.kcmo.com
PRUDENTIAL SECURITIES, INC.
One New York Plaza, New York, New York
(October 27, 1997) STOCK INDICES: It was another turbulent week for U.S. stocks, as overseas events overwhelmed the continuation of generally good third-quarter earnings reports that have been issued by the majority of American corporations. The dramatic collapse of the Hong Kong stock market, which posted a record one-day loss of 10.4%, torpedoed the U.S. equity market on Thursday. The market had begun the week in splendid fashion, with dramatic gains in response to good earnings reports by market giants IBM and Microsoft on Tuesday. That day, the Dow closed 139 points higher, bringing the week's upmove to a rousing 213 points. Just when it appeared that all systems were go for a potential assault on the all-time highs in the Dow and the S&P 500, the market fell a nominal 26 points on Wednesday and watched the bottom fall out on Thursday in response to the Hong Kong debacle.
Hong Kong's swoon, precipitated by a rise in the overnight lending rate to defend the local currency, resulted in a weekLy loss of an astounding 25%; the market has retreated 38% from the August highs. The ugly mood spread around the globe as Thursday dawned, with London falling more than 3% and Germany diving 4.7%. On a percentage basis, the Dow lost “just” 2.3%, even though Thursday's decline of 186 points was the fifth largest one- day point loss.
Friday's U,S. market action was disturbing. The Hong Kong market, which obviously had called the tune for all world markets on Thursday, made a very large recovery of 6.8% on Friday, thus setting up the U.S. markets for a handsome comeback to close the week. Although the Dow made an early gain of 90 points, it then abruptly changed course and plunged 245 points before ending 132 points lower on the day. Ironically, that level marked the week's loss as well because the Dow was unchanged for week as of Thursday's close, having given back all of the 213-point gain from Monday and Tuesday. The S&P 500 fared somewhat better, having been ahead 6 points for the week as of Thursday's close, only to lose 9 points on Friday, which made its weekly net change a loss of only 3 points.
Most bizarre about the latter part of last week was the strange inverse relationship between the stock and bond markets. Normally, lower bond yields (higher prices) are favorable for equities because they decrease the costs of corporate borrowing and provide less investment competition for stocks. However, the Hong Kong debacle caused bonds to register their largest gain in five weeks on Thursday; as the rally continued on Friday, the 30-year bond yield fell as low as 6.28%, which almost matches the lows for the year. Meanwhile, the equity market was falling apart. Indeed, Friday's low mark on bond yields was achieved when the Dow was on its low of the day, the ultimate example of the supposed “flight to quality” that benefited U.S. debt instruments.
A severe drop in gold prices on Friday to 12-year lows of $308 per ounce also helped encourage last week's anti- inflationary sentiment. Indeed, the devaluation of several Asian currencies means that a potential deflationary environment will be exported to U.S. shores. Last week's turbulent global action virtually eliminates the chance for an interest rate hike by the Federal Reserve Board in November, a factor that had been a source of concern recently.
The bond market had one of its best weeks of the year when the economic numbers were on the light side:
–The U.S. merchandise trade deficit rose 3.4% to $10.36 billion due to record imports.
–The Johnson-Redbook survey of weekly chain store sales rose by 0.2%.
–The Treasury announced that it will cut the size of the upcoming two- and five-year note auctions.
–Weekly jobless claims rose by 8,000 to the highest levels in nine weeks, which certainly alleviated some concern about tight labor markets.
Similar to the week before last, various Fed officials made their little noises about the usual topics. But, events in the Far East overwhelmed them as far as bond market reaction was concerned. Fed Vice-Chair Alice Rivlin said that growing labor scarcities were a potential problem and the Fed must be prepared to raise short-term rates to combat the situation. Atlanta Fed President Jack Guynn mentioned that the Fed was committed to maintaining monetary policy to keep inflation in check. San Francisco Fed President Robert Parry said economic growth was robust, but slowing somewhat and that inflation was “well behaved.” Richmond Fed President Broaddus said labor market conditions were particularly “robust” and was doubtful the good U.S. economic performance can go on indefinitely. Kansas City Fed President Thomas Hoenig commented that the U.S. economy is seeing solid growth with modest inflation, but that the Fed must be watchful amid very tight U.S. labor markets and a very high utilization rate. Chicago Fed President Michael Moskow said the strong U.S. Dollar has sparked a decline in import prices, helping to keep down inflation, but the dollar won't appreciate forever and cannot be counted on to reduce inflation on an ongoing basis.
What should have been the major focus of the stock market this past week–the torrent of third-quarter earnings reports–played second fiddle to the Asian market turbulence and its ripple effect around the world. In fact, these numbers have made for pleasant reading (although one would never know it by stock market action over the last two weeks). Of the 379 companies in the S&P 500 that have reported earnings for the third quarter, 216 firms, or 57%, have announced positive surprises, or earnings above analysts' forecasts. Meanwhile, 80 firms, or 21%, have matched analysts' forecasts, while 83 firms, or 22%, reported disappointing earnings.
So far, earnings are averaging about 13.25% above last year's third-quarter performance, following a gain of 11% in the second quarter. The best performing groups have been the airlines and truckers, which is one reason why the Dow Transports achieved an all-time high early last week. The third strongest group has been the brokerage firms. On the downside, shipping firms have shown the largest disappointments, followed by the food industry and electric -utilities.
Many stocks did well initially last week because of good earnings reports.
Stocks whose earnings were not up to snuff were punished, sometimes severely. Quite disturbing were the large number of stocks whose earnings matched or exceeded expectations, but whose prices fell nevertheless. Of course, this may partly be due to the old “buy on the rumor-sell on the news” syndrome, but in many cases the ostensible reason put forward was that earnings growth was going to “slow” in the upcoming quarters.
One old reliable item that has been extremely supportive to the market in general and to the specific companies involved has been the record pace of mergers and acquisitions. This process continued unabated last week.
Looking at the broader picture instead of the volatile day-to-day fluctuations, it is apparent that both the Dow and the S&P have remained within broad trading ranges for several months. For the last three weeks, for example, an outside event caused the market to retreat just as it seemed it was poised to make an upside breakout. For instance, three weeks ago, Fed Chairman Alan Greenspan warned that it would be “clearly unrealistic” to expect a continuation of the stock market gains similar to those of the last couple of years because continued upward revisions of longer-term corporate earnings expectations have driven price- earnings ratios to levels not often observed at this stage of an economic expansion. Two weeks ago, there was the media frenzy surrounding the tenth anniversary of the October 1987 stock market crash, which made for extremely nervous trading. Last week saw Far Eastern market woes descending an our shores; Friday's market sell off could be tied to a sharp drop in shares for semiconductor firms and semiconductor equipment makers after Intel said it would delay building a $1.3 billion plant in Texas due to slowing demand for flash memory chips.
Despite the market's poor showing last week, it has basically remained within its long-standing trading range of 7600-8300 for the Dow and 900-985 for the S&P 500. If these levels hold up, perhaps the market can mount another assault on the highs. However, this remains to be seen. Despite the market's overall production of better-than-expected earnings, the S&P is still trading at a 19:1 price/earnings ratio for forward earnings, which means that it is at the upper end of its post-war range. We hold a single spread position with the November S&P options,–long the 690 puts and short the 760 puts for a 30-point credit. We will add other positions as market conditions dictate.
Don Selkin
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