Confusion reigns

Market observations for the week of Aug. 16 to Aug. 20, 2010

Claymore Investments, Inc. 23 August, 2010 | 11:00PM

Over the past week there has been a lot of media hype over a technical phenomenon referred to as the Hindenburg Omen. Without getting into the gritty details, the indicator is triggered when a large number of new highs and new lows are made at the same time.

This is generally a signal of growing confusion in the marketplace and has often been a precursor to major corrections. While the Hindenburg Omen likely got a lot of attention due to its ominous name, confusion in the marketplace has been evident for quite some time. One only needs to look at the action in the bond market relative to the stock market for confirmation.

Bond yields have plunged to near-record lows (yields and price move in opposite directions) as investors appear to be positioning for a sharp slowdown in economic growth (double dip) and a possible bout of deflation. While the probability of either and/or both outcomes has been rising, ultimately neither outcome is a sure thing. On the other hand, the stock market, while down about 12% from the peak reached in late-April, still seems to be signalling a moderate recovery.

Bonds appear to be taking their cue from happenings in the domestic economy, whereas the stock market, while not ignoring the economic soft patch, may be taking some comfort in the economic conditions outside the United States.

As noted in these missives numerous times, the S&P 500 (our barometer for the market) derives nearly half of its revenues from outside the United States. While the U.S. economy appears to have hit a soft patch, other economies around the globe appear to be in much better shape. Last week, for example, Germany's central bank raised its 2010 growth forecast for Germany to 3.0% up from 1.9%.

In addition to the overseas exposure, corporate profitability in the United States has been very strong. Through Friday, 486 members of the S&P 500 have reported their second-quarter results, with over 75% exceeding analysts' expectations. In addition, according to data compiled by Bloomberg, earnings in the third and fourth quarters of this year are expected to grow by 24% and 32%, respectively.

Index Closing Price
8/20/2010
Week Ending
8/20/2010
Year to date
through
8/20/2010
Dow Jones Industrial Average 10213.62 -0.87% -2.06%
Wilshire 5000 Total Market 11043.35 -0.54% -3.31%
S&P 500 1071.69 -0.70% -3.89%
NASDAQ Composite 2179.76 0.29% -3.94%
S&P/TSX Composite 11722.07 1.68% -0.20%

Fed officials telegraphing more easing?

Major moves in monetary policy have traditionally been "telegraphed" by Federal Reserve officials well in advance of any actual move. Last week, St. Louis Fed President James Bullard may have tipped his hat slightly in respect to further easing. Mr. Bullard, speaking in Arkansas, said that additional quantitative easing measures may be warranted and that it would not be prudent to rely solely on rate policy to keep the U.S. out of a deflationary environment. With that said, Mr. Bullard remained generally upbeat on the outlook for U.S. economic growth, suggesting that further policy action is not necessary for now. Thus additional quantitative easing measures would likely only be implemented if economic conditions turned significantly worse.

This coming week, the Kansas City Federal Reserve holds its annual symposium in Jackson Hole, Wyoming. Fed Chairman Bernanke is scheduled to deliver a speech Friday morning titled "The Economic Outlook and the Federal Reserve Policy Response." There has been growing speculation that Mr. Bernanke may use this forum as an opportunity to signal that additional stimulus measures are likely.

The issue then becomes one of timing. As we know, mid-term elections are scheduled for Nov. 2. It just so happens that there is a FOMC meeting scheduled the very next day. Although the Fed is considered an independent entity, a move to stimulate the economy ahead of the election would likely be considered politically motivated. Waiting until Nov. 3 to announce new stimulus programs would eliminate any signs of political bias and more importantly, it would give the Fed more time to evaluate incoming economic data and whether additional stimulus is actually required (re: Bullard's last point).

Further signs of economic weakness...

Last week several pieces of economic data stoked fears that the U.S. economic recovery is starting to roll over. Two reports in particular, the weekly initial jobless claims and the Philadelphia Fed Business Outlook Survey, set the tone.

Last week the U.S. Labor Department reported that initial claims for unemployment benefits rose to 500K in the week ended Aug. 14, the highest level since mid-November. Because claims are notoriously volatile, the four-week moving average is typically used as a way of smoothing the week-to-week volatility.

The bad news is that the 4-week moving average climbed to 482.5K -- the highest since last December. The elevated level of claims is raising fears that private payrolls may contract in August. Since the headline nonfarm payrolls number has been downplayed recently due to the distortion from the 2010 Census, the focus has turned to the private payroll component (which filters out government hiring/firing). Private payrolls turned positive at the beginning of this year and have averaged 90K job additions per month. While far from robust, the number has been in a steady progression over the past three months. A negative reading (next report is due out on Sept. 3) would clearly be a setback and would likely be adversely received by the market.

In regards to the Philly Fed report. The Philly Fed Index is a monthly update on the state of manufacturing activity in the greater Philadelphia region. The Index fell to negative 7.7 in August from +5.1 in July (the Index is a diffusion index where readings below zero indicate contraction). This was the first reading below zero since July 2009 and was significantly below the +7.0 reading expected by economists. The Philly Fed report follows the Empire Manufacturing report (reported on Aug. 16) that showed manufacturing conditions in the greater New York area continue to slow. The manufacturing sector has primarily been the driving force behind the economic recovery. Last week's data, may have called that into question.

… But not all was bad.

While the economic indicators mentioned above set an overall negative tone, there were some glimmers of economic hope reported last week. Mortgage applications rose by 13%, fuelled by a 17% surge in refinancing activity. Housing starts rose 1.7% in July while industrial production rose by a better-than-expected 1.0%. Also of note, the Federal Reserve's quarterly senior loan officer survey showed that banks generally eased lending standards during the second quarter.

Looking ahead

With only 14 companies in the S&P left to report, the earnings calendar will be pushed to the back burner for the next couple months. This week's economic calendar will feature housing-related data (existing home sales, new home sales and mortgage applications), durable goods orders and initial jobless claims.

Also of note will be the revised second-quarter GDP report on Friday. Economists are looking for a sharp downward revision to the initially reported 2.4% growth rate due to the higher-than-originally estimated level of imports (note: imports are deducted from GDP and are estimated in the initial release of the GDP data).

Trading range intact

Since the beginning up June the S&P 500 has been stuck in a trading range between 1130 on the upside and 1050 on the downside. Trading volumes have been anaemic as it appears many investors have taken a vacation away from their investment portfolios. The sideway slog has been a result of the uncertainty surrounding the pace of the economic recovery, which has generally offset the better than expected second quarter earnings that have been released over the same period.

The question now becomes what will be the catalyst to push the markets above the upper end of the range. While better news on the economy would likely do the trick, it will likely be a catalyst that will need time to develop. A quicker fix would be a policy-induced directive. This could be something along the lines of extending the Bush tax cuts, a program to incentivize hiring by small business, a mortgage forgiveness program, etc. While these initiatives would be "band aid on broken arm" solution, they would help renew some much needed confidence in the marketplace and buy time for the economic recovery to further develop.

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Claymore Investments, Inc.

Claymore Investments, Inc.