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PRUDENTIAL SECURITIES, INC.
One New York Plaza, New York, New York
(August 18, 1997) STOCK INDICES: August has not been kind to the Dow Jones Industrial Average, which posted a record one-week loss of 337 points last week with a Friday drop of 247 points. We believe Friday's action was technically inspired, but likely confirms that the intra-day high made on August 7 at 8300 may stand for a while.
Here's a brief synopsis of the stock market's recent travails: The Dow registered its largest one-month point gain in history in July, up 550 points, and was accompanied by the lowest bond yields in 17 months (6.29%). The party continued until Thursday, August 7, when the results of the 30-year bond auction (the third leg of the quarterly refunding package) were announced. Initially, the bond and stock markets reacted positively, as the results came in slightly better than anticipated. But after a brief upside flurry, with the Dow touching the 8300 level and the S&P 500 reaching 964, both stocks and bonds abruptly reversed course to the downside, establishing a “key reversal” with a 40-point Dow gain on the high side that day ending with a closing loss of 70 points.
The next day, August 8, financial markets cratered, with bonds down almost two full points, which brought the yield up to 6.66%. This action caused stocks to cave in too, with the Dow falling 157 points, its eighth-largest single-day point loss; breadth numbers were horrendous as well, on the order of six stocks down for every one stock up. Ironically, it was not a major economic report that caused this collapse, but rather the ostensible news was that the dollar weakened sharply. The dollar had been gaining rather dramatically against other currencies all year, a continuation of its steady uptrend since reaching its post-war lows in the first quarter of 1995. A setback in the dollar, considering the extent of its rise this year, should not have had this dramatic effect on the stock market. Indeed, the stock market's plummet on August 8 really could be viewed as a technical confirmation that the prior day's lower close had validity in terms of establishing that a top had been made on August 7.
A more disturbing pattern for equities developed last week. Stocks continued to weaken substantially as bonds rallied a bit (bringing the yield back down to 6.56%)–and the way in which stocks fell was ominous. On Tuesday, August 12, the Dow started out with an early gain of 30 points and ended with a 100- point loss. On Wednesday, following release of friendly Producer Price Index and Retail Sales reports, the Dow started out with an early 80-point gain, which immediately proceeded to turn into an 80-point loss, before finally closing with a loss of 32 points. Wednesday, August 13, is a day that will go down in history as arguably the wildest day in market history, with the Dow traversing a course of 900 points intraday (a market record) as it changed direction from positive to negative 14 times.
A similar pattern emerged last Thursday. The Dow came out of the starting gate with a 70-point gain, which proceeded to turn into a 50-point loss before a late comeback resulted in a 13-point closing gain. But it was again disturbing that stocks could not do better, especially because bonds once again reacted very favorably to the Consumer Price Index and Industrial Production and Capacity Utilization reports. Last Friday's closeout session was one for the record books. The Dow, weakened from the opening by the effect of the August expiration series, went into a sickening last-hour free fall to end with the second-largest point loss in history, down 247. For the week, the Dow set a record by losing 337 points over five days, closing at 7694, its lowest level since June 30. For the six-day period under review, the loss was 494 points.
Ironically, the economic news released last week should have provided support for equities, as it basically continued the slow-growth, non- inflationary scenario that the stock market has come to love in 1997:
–The Atlanta Fed Index rose to 23.3 from 15.3 in June, but the prices paid component fell.
–Non-farm productivity rose 0.6% in the second quarter versus 1.4% in the first quarter.
–The Johnson-Redbook survey of weekly chain store sales rose 0.9%, which was larger than expected and caused the bond market to incorrectly believe that the July retail sales number would be strong as well.
–July retail sales rose by only 0.6% (0.5%, excluding autos). These numbers were slightly less than expectations.
–The July Producer Price Index fell 0.1%, which was a record seventh consecutive monthly decline; the core rate, which excludes food and energy, also fell by 0.1%. For the year, the PPI has declined at an annualized rate of 3.5%.
–The July Consumer Price Index rose by 0.2%, as did the core rate. It has risen for the year at an annualized rate of 1.5%, which is the lowest since 1986.
–July Industrial Production rose 0.2% and Capacity Utilization declined slightly to 83.1%.
–Weekly jobless claims rose by 12,000 to 316,000.
–Business inventories for June rose 0.7% for their sixth consecutive monthly gain.
–Real average weekly earnings in July fell 0.1%.
–The University of Michigan Consumer Sentiment Survey fell to 102.8 in August from 107.1 in July; the expectations and current conditions numbers fell as well.
Federal Reserve Governor Susan Phillips reassured the bond market when she said that the Fed is not poised to raise rates again to slow growth and head off inflation. Fed Governor Edward Kelley spoke about labor market tightness not yet being inflationary and also mentioned that concrete “pipeline” price pressures were not up.
It would almost certainly appear as if the Federal Open Market Committee will stand pat on the interest rate front at this week's meeting on Tuesday, August 19, especially considering the economic data confirms a moderate picture. The bond market reacted as it should have to these very benign numbers, rallying modestly for the week. Yields fell to 6.56% from the previous week's level of 6.66%, thereby making last week's bloodbath in stocks even more disturbing.
Technically, the first sign of an overbought situation was that 80% of stocks were above their 200-day moving averages in late July. Also, you must consider that the Dow rose 2000 points from mid-April to early-August. As solace to the bullish contingent, these huge losses of the last several days have to be put in that context. Perhaps a healthy correction will cleanse the market of some of its overbought readings, thereby spurring further upside probes. But, as market action of the last several days has indicated, the path of least resistance is down for the time being.
We currently hold the following positions with the S&P options: (1) buying the September 650 put and selling the September 755 put for a 25-point credit; (2) buying the August 680 put and selling the September 720 put for a 30-point credit; (3) buying the August 690 put and selling the September 725 put for a 25-point credit; and (4) buying the August 675 put and selling the September 700 put for a 30-point credit. Our long August 660 put/short August 670 put position expired worthless our way and we retained the entire premium. Given the market's extremely severe downside correction, we would only add other positions if market conditions justify such action.
Donald M. Selkin
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