THE MARKETS
A deluge of bad corporate and economic news sent stocks reeling as both the Dow Jones Industrial Average and the NASDAQ ended the week in negative territory. The Dow (which was down on four of the five trading days) closed below 8000 on both Thursday and Friday. This marked the first time that the Dow has closed under the 8000 mark since July 23rd when the index closed at 7702.34. The NASDAQ also took it on the chin as it closed below its July low on Thursday. For the week the Dow lost 326 points (-3.9%) and settled at 7986. The NASDAQ ended the week at 1221 down 78 points (-5.3%).
The market may be facing a number of risks – a potential war with Iraq, rising consumer debt, concerns over housing prices and continued corporate governance issues – but all of these pale in comparison to the concerns over corporate earnings. Warnings from the likes of Electronic Data Systems (EDS), JP Morgan/Chase, Duke Energy, IBM and Morgan Stanley continue to plague the markets, as does the renewed possibility of additional criminal indictments against executives at both Credit Suisse First Boston and Solomon Smith Barney. Throw in good news from Eastman Kodak, Qualcomm and FedEx and you have just enough optimism to keep the markets afloat.
THE COMPASS PORTFOLIOS
Given the volatility of the markets and the lack of follow-through on the August rally, we continue to be comfortable with our neutral posture (40% Equities, 40% Money Market/Cash, and 20% Bonds). The discipline of the Compass Portfolio management process has benefited our clients in the past, as portfolio assets have generally declined much less than the overall indexes. Investors have been very patient in working through the difficult issues of the past several months, and we believe that patience will eventually be rewarded. That being said, we are increasingly skeptical that an immediate market recovery is in the works, as we have seen little evidence that corporate earnings have fully (or even partially) recovered.
We are very aware of the fact that the equity markets tend to overreact both to positive news and to negative news; the recent market downturn is no exception. Our portfolio management discipline recognizes this phenomenon and reacts to it, positioning client assets to take advantage of favorable markets and to minimize the damage of negative markets. While we currently carry what we believe to be a prudent equity exposure, we are by no means fully invested, and therefore are not currently experiencing the full brunt of the renewed downturn. We continue to anticipate higher equity prices in the future, but we will move forward cautiously, always with the best interest of our clients in mind.
THE ECONOMY
The economy is struggling mightily to stay afloat, aided mainly by optimistic consumers who continue to buy homes and new cars, travel and shop, typically borrowing heavily to fund their purchases. According to government figures released on Sept. 13, retail sales jumped 0.8% in August — the third consecutive month of gains. Consumer credit rose 7.6% in July, to a record $1.7 trillion, driven by credit-card use and auto financing. Fueled by historically low interest rates, mortgage applications and refinancings are at all-time highs.
Contrast this behavior with that of businesses: Instead of borrowing and spending, corporate execs continue to focus almost exclusively on cutting costs and repairing their balance sheets. Instead of investing, many leading companies have been quietly amassing mountains of cash. Microsoft probably has the biggest pile. Its June, 2002, balance sheet shows that it has $38.7 billion in cash and short-term investments, up from $31.6 billion the year before. As of June, 2002, General Motors had $19 billion in cash and short-term investments, Pfizer had $11.3 billion, and Intel had $10.3 billion.
Companies are also borrowing a lot less. According to the Federal Reserve, bank business loans are down by more than 7% from a year ago. The monthly pace of investment-grade corporate-bond issuance averaged $57 billion a month in the first half of the year. But in the third quarter it’s likely to fall to $31 billion, according to Moody’s Investors Services estimates. This drop would come despite borrowing costs being at their lowest since the late 1960s.
The Consumer Price Index for August showed a gain of 0.3% versus +0.1% forecast by Dow Jones Newswires. As strange as it may seem, the unexpected rise in the overall and core CPI may be good news as it helps quell deflation fears. Within the Fed’s quest for price stability, they attempt to avoid deflation because such expectations of price decreases can inhibit economic growth because consumers are more prone to postpone purchases in that environment. Inflation does not presently appear to be a threat to price stability either. However, it is fair to say, based on this report, that inflation, while palatable, is not as tame as previously thought. Taken all together, the most likely outcome is for the Fed to maintain their steady interest rate policy.
