THE MARKETS
The market went on a wild ride last week as volatility increased, volume surged and prices fell sharply. When the dust settled, all of the major averages were down sharply. During the week the NASDAQ, AMEX, S&P 500 and the DJ Utility Index fell to levels not seen since 1998. The Dow Jones Industrial Average, which was down on all five trading days, lost 695 points (-7.4%) for the week and closed at 8684. On a percentage basis, the NASDAQ fared a touch better as it lost 75 points (-5.2%) and settled at *1373.
Breadth was bearish last week as the NYSE Advance/Decline line lost 4105 units while the number of NYSE stocks making new 52-week lows exceeded those making new highs on four of the five trading days. The percentage of NYSE stocks above their 200-day moving average dropped to 32.8% from 38.1% while those above their 50-day fell to 13.0% from 16.5%
The percentage of bullish investment advisors declined to 39.8% from 44.0%. Readings below 35% are considered bullish. The CBOE Volatility Index remained in bullish territory at 38.64 up from 33.31. On Wednesday the VIX indicator topped 39, the highest reading since 09/24/01. Readings over 30 are considered bullish. Mutual funds had cash outflows of $3.2 billion for the period ending July 10th compared to outflows of $4.0 billion the previous week.
There is a potential firestorm brewing in Washington over employee stock options, and how companies who offer them account for them on their balance sheets. In an attempt to clean up corporate accounting, the senate is proposing legislation requiring companies to account for stock options as an expense. This could be a significant drag on future earnings, as many companies who previously “gave away” shares to valuable employees now have to find a way to actually pay for them. How much? Merrill Lynch recently reported that for the current year results may have to be reduced market-wide by approximately 10%, with many technology companies reducing earnings by as much as 65%.
THE COMPASS PORTFOLIOS
As has been the trend for the last twelve weeks, we continue to be defensive, given the current state of the markets. Institutional support for equities is practically nonexistent, which leads to large scale selling and lower equity prices. We currently hold minimal positions in large-cap value (energy, banking, pharmaceuticals, etc.), in essence to have a foothold in the market, given the improving economic background. We also hold significant positions in bonds and money market instruments, both defensive investments.
THE ECONOMY
Despite all the uncertainties, the economy looks resilient. The litany of troubles plaguing the financial markets have become all too familiar. Accounting, corporate and analyst credibility still linger. Terrorism, the war against it, including possible U.S. military action in Iraq, along with Middle East and other global tensions dominate the headlines with seemingly no end in sight. Of course, corporate earnings downgrades have also taken their toll. Despite all these negative influences, it is important to remember that the U.S. economy has held up reasonably well. Even though the economy has its share of uncertainties and future economic reports could disappoint, a closer look at some important fundamentals indicates the overall recovery still appears positive.
On June 7, it was reported that inventories at the wholesale level fell 0.7% in April, representing the 16th consecutive decline. That can be a problem if corresponding sales are also falling. Currently, this is not a concern as sales grew 0.1% in March and then skyrocketed 1.6% in April. If the trend continues, production and eventually employment could start to ramp up.
The real juice the Fed ultimately provides the economy is liquidity. This comes in the form of money supply. Just as monetary policy has a 6 to 9 month lag, and longer for some aspects of the economy, so too does money supply growth. After gaining ground through the latter portion of 2001, money supply growth began to decelerate in the first quarter of 02. Consequently, last week’s upbeat economic news could be the result of last year’s liquidity improvement, but we could also experience some disappointing economic news in the near-term, since money supply started to show small signs of real growth this quarter only to stagnate in the last few weeks.
Think of it this way, reduced growth rates of money supply can slow the economy in a manner similar to Fed rate hikes. This is one of the main reasons why the Fed is on hold. In fact, some have suggested that the next move by the Fed could be another rate cut. That’s right — a cut — if money supply and other factors deteriorate.
Another source of liquidity comes from home refinancing activity. If you look at the string of events, the stabilizing effect of mortgage rates could indeed improve liquidity. Depressed stock prices and global tensions have resulted in flight-to-safety buying of U.S. Treasury securities, thereby pushing yields down. With mortgage rates directly correlated with the 10-year Treasury note, the recent drop in yield continues to enhance the attractiveness of mortgage rates. As of June 20, the national average of the 30-year fixed-rate mortgage, per Freddie Mac, fell to its lowest level in 31 weeks at 6.63%, 55 basis points below its March 2002 peak of 7.18%. As you might have expected, refinances have risen, up 4.2% through the week of June 14 and 23.7% higher over the last four weeks!
In conclusion, the slope of the economic recovery is still positive. While the economy is still subject to some setbacks and more liquidity growth is needed, the fundamentals currently look relatively good — not great, but resilient. All the uncertainties have been weighing on investor psychology. Certainly, it is difficult to ignore them because they might get worse before they get better. However, the overall U.S. economy is a bright spot. If it continues to improve, it is only a matter of time before these positive developments translate into better profits for U.S. corporations.
