Amid fears that the economy could be headed for a double-dip recession, stocks took it on the chin for the fourth week in a row. All of the major averages, with the exception of the Dow Jones Transportation and Utility Indexes, finished the week in the minus column. The Dow Jones Industrial Average lost 115 points (-1.2%) and closed the week at 9474, its lowest level since last November. The NASDAQ was down on three of the five trading days as it lost 31 points (-2.0%) and settled at 1504.
Recent encouraging signs from the economy have been overshadowed by sector-specific events lately, and investors have shown little tolerance for risk. Many traditional value indicators are now signaling that the market may be entering oversold territory but near term technical and sentiment indicators remain negative. Summertime, historically not a traditional strong season for the stock market, has been one of the better periods over the last several years. But the slowed pace of business investment activity may be more of a hindrance this year. Investors seem unwilling to pay up for anything but revenue driven profit growth; even productivity-driven profit growth doesn’t cut it. The sultry summer months are unlikely to mid-wife a sudden revival in capital expenditures. That could leave investors stuck in bearish mode, or at least prevent bullishness from taking hold.
The themes that have dominated 2002 — corporate malfeasance and aggressive accounting, anxiety over terrorism, flaring regional conflicts, and stagnant business investment — persisted and in several cases intensified over the past month. Against this worsening backdrop, renewed attempts to ignite a market rally have instead triggered deeper selloffs. Investor confidence in top management at U.S. corporations was further eroded by the resignation of Tyco CEO Dennis Koslowski, on allegations of sales-tax fraud, and the widening FERC inquiry into energy trading practices during California’s electricity crisis. Internationally, the massing of more than one million troops on either side of the Pakistani-Indian border heightened the possibility of a nuclear exchange. Terrorism concerns mounted on news that a Chicago-born man was being held for his involvement in a radioactive “dirty” bomb plot. The stock market might have been able to treat all this as so much background noise if capital spending were rising, resulting in strong top-line growth. Instead, capital spending remains anemic, a situation not likely to change much during the slow summer months. Amid widening allegations of top management improprieties, investors have grown suspicious of net income improvement tied merely to productivity and not to top-line growth. Any improvement in revenue will be gradual, reflecting the extreme caution of top managers about new spending initiatives. Altogether, we suspect this market will have to claw its way back up.
THE COMPASS PORTFOLIOS
We have reluctantly reduced the minimal positions we had been holding in client portfolios, responding to the continued weakness in the equity markets. Due to the increasing evidence of an economic recovery, we had been reluctant to completely eliminate our positions in large-cap and small-cap value equities, but have taken additional steps to follow the bearish trend of the market.
It will likely be several weeks before the tone of the market changes, as large institutions (which determine the direction of the market) tend to be less active in the summer months. However, we will continue to monitor trends closely, and look forward to a renewed up-trend.
Last Monday we wrote that the stock market might continue to sputter despite good economic news – because of geopolitical uncertainties. The outlook now appears to be more upbeat globally, just as fresh concerns emerge over the U.S. economy. First the good news: tensions between India and Pakistan have cooled, as the remote possibility of a nuclear war has receded further. And President Bush’s endorsement of a Palestinian state will begin a prolonged diplomatic dance that should revive “the process” and possibly reduce tensions in that part of the world. But as last Monday morning’s Wall St. Journal wrote, there’s new anxiety over the U.S. economy, which clearly hit a soft patch in May.
As we have indicated over the past several months, the likely outcome for the economy still seems to be moderate (3 percent) GDP growth, low inflation, great productivity, improving corporate profits – and the Fed staying on the sidelines for months to come. Not a bad scenario, especially if geopolitical concerns ease a bit.
The May retail sales report was much weaker than our optimistic expectations and suggests a potentially softer recovery than we initially estimated. The housing-related components were solid, and in some cases, torrid. Sales at electronics and appliance stores surged 2.1% in May, or 10.9% over the past 12 months. Meanwhile, furniture and home furnishing retail sales rose 0.9%, or 5.6% since May 2001. Retail sales of sporting goods, hobby, book and music stores rose 1.0% in May, or 7.6% over the last year. Obviously, the beginning of the summer vacation season had elevated spending in that category.
Consensus forecast of 3.1% growth in the second quarter and 2.5% in the second half is already softer than Street consensus. It is very likely we will not see blistering growth coming out of the recession that we experienced last year. New claims for unemployment insurance benefits rose by 6,000 to a seasonally adjusted annual rate of 390,000, slightly higher than the one-year low of 384,000, registered last week. Despite the nominal increase, the report is consistent with other labor data suggesting a slow, but sure, recovery. The Federal Reserve’s latest beige book referred to “slack” labor market conditions. However, it cited numerous improvements in temporary employment in many of the districts, which is atypical of the early stages of economic recovery. Before businesses assume the costly venture of hiring full-time workers, they add temporary workers. This way, if the recovery turns out to be real, they can then add to their workforces. If not, they can dismiss the temps.
WORDS OF WISDOM
“Put not your trust in money, but put your money in trust.”
-Oliver Wendell Holmes