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PRUDENTIAL SECURITIES, INC.
One New York Plaza, New York, New York
(October 13, 1997) STOCK INDICES–Just when it appeared that the “Goldilocks” scenario of steady economic growth with no inflation was alive and well again, financial markets were hit by a triple whammy last week, with unexpected bearish news on Wednesday, Thursday and Friday. As a result, the long bond yield, which had reached a 19- month low on Tuesday of 6.24%, rose to 6.43% by week's end. Every measure of the stock market except the Dow (which was only 80 points away from its best-ever level) hit all-time highs on Tuesday only to feel pressure the rest of the week.
The abrupt reversal started on Wednesday, with the testimony of Federal Reserve Chairman Alan Greenspan to the House Budget Committee. He spent much of his time discussing his view of tightness in the labor market and said that he saw a strong chance of wage pressures ahead adding that inflation could rise unless there is a “marked slowing” in the demand for goods and services. In a vague replay of the now infamous “irrational exuberance” comment of last December, Greenspan said it would “clearly be 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.” He also debunked the au courant “new economic paradigm” by proclaiming that such a condition would be possible only when price pressures rarely increase because low-cost domestic and foreign capacity would be able to absorb surges in demand.
On Tuesday, just before Fed Chairman Greenspan's bearish rumblings came out, the markets were helped by Fed Vice Chair Alice Rivlin's comments that she was surprised by the absence of major wage and price increases given tight U.S. labor markets, describing these favorable developments as a “mystery.” Another mystery to her was that whatever increases the United States has had in wages has not yet translated into higher prices.
Adding to the market malaise was a prediction (for what it was worth) by former Fed Governor Lyle Gramley that the Fed will tighten monetary policy by hiking both the fed funds and discount rates by 25 basis points before the end of 1997. Ironically, it was only last Monday that New York Federal Reserve President William McDonough said that there is “nothing on the political or economic horizon” which hints that oil prices, which had surged the week before last due to potential Mideast tensions, are about to become an immediate inflation concern.
The second of the triumvirate of bad news came on Thursday, as the German Bundesbank raised its securities repurchase rate to 3.3% from 3%–its first rate increase in five years, Other European central banks followed suit, with intervention rates rising in France, Austria, the Netherlands and Belgium.
The third piece of market indigestion came on Friday in the form of the September Producer Price Index, which rose a larger-than-expected 0.5%; also, the core rate rose by a larger- than-expected 0.4%. This was the second monthly PPI increase after seven months of declines, and it was the largest rise since December 1996. Closer scrutiny of the numbers showed that the bulk of the increase came from jumps in tobacco, passenger cars and trucks. Without these potential one-time increases, the index gain would have been only 0.1%.
Aside from the drama of the PPI number, the economic releases last week were on the light side, basically showing more of the same, namely tight labor markets but with no evidence of a pick up in inflationary pressures or excessively strong economic growth:
–August consumer credit rose by $4.3 billion, down from the prior month's gain of $6.5 billion.
–The Johnson-Redbook survey of weekly chain store sales fell by 1.1%.
–Weekly jobless claims fell 5,000 to 304,000, which meant that this is the first time since January 1989 that the four-week moving average has fallen below 310.000.
Despite all of these potential negatives, the stock market's reaction was not all that terrible, especially considering that the bad news hit after every broad measure had achieved all- time highs last Tuesday. In addition, the Dow had registered five consecutive gains for the first time since late July, when it was on its way toward the all-time high of early August. Even with the sharp drops seen late in the week, both the Dow and S&P 500 closed virtually unchanged for the week. The NASDAQ achieved six consecutive record high closes before the streak ended on Friday. The Russell 2000 index continued to roll along, attaining new record levels on Friday, for its 26th higher close in the last 34 sessions.
A good portion of this strength in stocks had to be due to flows into equity mutual funds, which continue at an extremely strong pace. In September, $21.5 billion was received, a big increase from the $13.9 billion taken in during the difficult month of August. For October, the projection is for an inflow similar to that of September, but it is too early in the month to confidently predict that this will occur.
Another supportive factor has been the record pace of mergers and acquisitions, which is running well ahead of last year's record $650 billion pace. When companies merge, it is bullish because stock supplies are taken off the market.
The third-quarter pre-announcement period is over, and reports from about 200 companies did not make for very pleasant reading, with more than 90% saying that earnings will be below forecasts. As we have been pointing out, although individual companies have been getting punished because of this news, you have to marvel that the overall market has held up remarkably well. It appears that better days could be ahead when the third-quarter figures come out in earnest. Indeed, they already have begun to appear, although it is too early to get a sense of the how many companies will beat the analysts' predictions. This information will be available in our report next week. It is currently perceived that third-quarter results will be better than expected, up perhaps as much as 14% rather than the 12% gain originally predicted. This belief has supported the market despite the torrent of negative pre-announcements and the bond market's sharp sell-off last week.
Futures and options contracts on the Dow Jones Industrial Average opened on October 6. Similar to the S&P 500, they trade on a quarterly cycle of March, June, September and December. The contract value is 10 times the underlying measure itself, or $80,000 if the Dow is at 8000. The minimum tick is one point, which is equivalent to $10. We had mentioned in last week's newsletter that it would be interesting to see if program trading increased with the advent of these contracts, and it appears there was one obvious instance near Tuesday's close. That day, the Dow was higher by about 50-60 points for most of the session, but the December premium expanded late in the session to a level much higher than fair value, which induced late buy programs that sent the Dow to close with a 78-point gain. Ironically, this was the high for the week, as the “bad news” began to take over the next day.
Despite the market's hesitation last week, we still believe that it should not fall too much further, especially now that earnings reports should take center stage. As a result, we added another bullish spread position, buying the October 790 S&P puts and selling the November 760 puts for a 35-point credit. This position is in addition to the October S&P spread already in place (buying the 680 puts and selling the 750 puts at a 30-point credit). We will recommend other positions as market conditions dictate.
Don Selkin
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