The Dow managed to put together four straight up days for the first time since late January 2002 as the bulls made headway for the third week in a row. For the period the Dow Jones Industrial Average gained 432 points (+5.2%) and closed at 8745. The NASDAQ also settled on the plus side after falling for the last four weeks. For the period the NASDAQ gained 59 points (4.7%) and finished at 1306.
The Federal Reserve uses a model which helps to determine whether the market is over or under valued. It compares the earnings yield of the S&P 500 to the current yield on the 10-year Treasury note. When the forecasted earnings yield is greater than the Treasury rate, the market is considered to be undervalued. As of the close on August 2nd, the market was more than 30% undervalued based on this model. This is the lowest reading in over 20 years.
Generally positive moves on Wall Street during the past week took place in the absence of any substantial news, and were fueled by hopes for Alan Greenspan to again lower interest rates. The market swung back and forth violently on Wednesday and Thursday until bulls rushed in each day through the close despite the lack of inspirational news headlines. Many market analysts say the volatile action is part of a bottoming process, and that we may be in a base building process, indicating that the worst may be behind us.
That said, before investors get caught up in a frenzy to drive stocks dramatically higher, there are a few nagging issues that the market must face. First, technical resistance will be high as bottom-fishing investors take profits. Second, corporate executives are going to have to start making capital investments again – and the financial markets are going to have to lower the costs of raising capital. Third, expectations for earnings turnarounds in the third quarter are still too high in certain sectors, including Financial Services and Technology. The third-quarter earnings warning period could cool off this late-summer rally.
Some fundamental reforms in the market are coming to the fore, and investors are responding to the positive news. The early sign-off on corporate financials by Cisco and Citigroup no doubt injected a dose of confidence into the markets. An increasing number of companies are announcing that they will treat options as an expense. Wall Street analysts are now going to have to certify their recommendations. Collectively, these measures, along with reform proposals from Congress, the New York Stock Exchange, and other regulatory bodies are starting to take hold.
THE COMPASS PORTFOLIOS
The portfolio recommendations made over the past four months have helped our clients avoid a significant amount of market risk, and have kept many of our clients in favorable financial condition. Money market and other defensive positions remain at high levels, as we await the arrival of a sustainable change in market direction. We have added a minor position in large cap value to most portfolios, to protect our clients from missing out on additional short-term upside in the Dow Jones Industrial Average. As of the close on Friday however, our models have yet not turned positive, although as mentioned above a bottoming process may be in place. The upward move we had this week is best viewed as a rally in a sustained bear market, and until we receive confirmation that institutional money managers are collectively spending cash, our models will continue to be defensive.
We agree with the prevailing sentiment among many professional money managers that a considerable amount of damage has been done to investor confidence. Let the healing process begin, led by meaningful reforms in accounting, executive accountability, and analysis.
The bond market is increasingly looking for some action from the Fed next week, be it an actual rate cut or a mere shift in the bias back to easing. S&P still sees the odds of either event rather low, especially since it was only a few weeks ago that Fed Chairman Alan Greenspan indicated that the economy was doing well. Articles Friday morning in the Washington Post and the Wall St. Journal by highly regarded Fed reporters both contend that a rate cut is unlikely next Tuesday. We agree. But the articles left open the possibility of a bias shift on Tuesday, accompanied by an FOMC statement that will hint of possible easing this fall if the economy doesn’t pick up. It’s unrealistic to expect a rate cut next week, and these articles may have been Fed “leaks” to make sure the stock market isn’t getting ahead of itself. Former Fed Gov. Lyle Gramley still thinks the economy will grow well below potential in the coming months, with a threat of disinflation or even deflation — a combination that could prompt rate reductions this fall.
A caveat: the key factor, as usual, is the stock market. If a bottom is in place, and this week’s rally continues for the rest of the summer, Fed officials might hold back on rate cuts. But that’s a very big “if.”
In economic news Wednesday, U.S. wholesale inventories rose 0.3% in June — the first increase in more than a year — after a revised flat reading in May (from up 0.1% previously). Sales jumped 0.6%, following a revised unchanged reading in May (from down 0.2% previously). The inventory-to-sales ratio held steady at the record low of 1.23. The data was stronger than expected and signal that businesses have started building inventories in anticipation of an economic recovery.
Meanwhile, the Labor Department said that prices of imported goods rose 0.4% last month, after falling 0.3% in June, thanks to higher petroleum prices. Export prices climbed 0.3% after a flat reading in June, driven by rising food prices.