Market Undergoes Second Largest Correction This Year as It Awaits the Fed

Adding to the recent theme that the market was in “need of a rest” as I mentioned in this column two weeks ago, the downside has continued and reached a 3.7 percent S&P correction off of the August 2 all-time highs to start the new week. In the process, both the Dow and the S&P have declined for four days in a row as of Monday, the longest such stretch this year, and have been down in nine out of the past 11 sessions in the process. Monday’s additional market setbacks followed last week’s Dow decline of 2.2 percent, its worst one-week loss since June 2012 while both the S&P and Nasdaq endured their poorest weekly showing since the third week of June 2013. That decline has so far marked the worst performance for the S&P this year, which was the 5.8 percent decline off of what was then the May 21 all-time prior highs.

And once again, it was the same old themes that have spooked the market lately that keep coming into play, the main one being the anxiety over some sort of Federal Reserve tapering of the current $85 billion a month stimulus programs that are now in effect. These programs consist of purchases of both longer-term Treasury securities and mortgage-backed securities as well, which allowed home mortgage rates to reach all-time low levels in the past year and have certainly been a factor behind the strength in the housing market. And housing has been one of the linchpins underlying the current economic recovery that is presently under way.

In addition, investors are still anxious over a word that was a big anxiety producing item earlier in the year, namely the “sequestration” process that would involve further federal budget cuts and layoffs in addition to the question of raising the federal debt ceiling before the end of the current fiscal year that ends on September 1.

All of these factors plus a lackluster end to the second-quarter earnings season that has now seen the overall result pushed down to a profit advance of only 3 percent from as high as 4.8 percent earlier, has also increased anxiety among investors. In addition, the projection for third-quarter earnings growth has been slashed by more than a third since the end of June, down to a current estimate of 3.9 percent.

As is usually the case, most companies did beat their profit estimates for the second-quarter, but the average size of the beat was only 2.4 percent, which is less than the past four-year average of 7 percent. To put the icing on what has certainly turned out to be a less than stellar reporting period, the financial sector basically was responsible for all of the earnings growth. In other words, if these results were subtracted from the total S&P earnings report card, the final number would have actually been a 3 percent decline from last year’s second quarter!

And to compound investor fears, of the almost 100 S&P companies that have already issued third-quarter earnings guidance so far, more than 80 percent of them have guided lower and this compares to the average 62 percent over the last five years.

And as Treasury yields have been moving higher, the worst performers have been the groups that traditionally pay the highest dividends, such as telephone companies, utilities, pharmaceuticals and consumer staples.

But not all the news has been negative, as there have been more optimistic reports out of China which were detailed in last week’s column in terms of better exports and imports as they try to put a floor of 7.5 percent under their economic growth prospects.

And believe it or not, even though the bond market has taken for granted that some sort of easing will be on the way at next month’s F.O.M.C. meeting by raising yields on the all-important 10-year Treasury security to a two-year high of 2.88 percent on Monday, there are still some dissenting voices among the voting members of the committee.

For instance, St. Louis Fed President James Bullard said just last week that low U.S. inflation is worrisome for the country’s economy and there is not much evidence that it is heading higher. He mentioned that “[i]nflation has been running very low and I have been concerned about low inflation as there has not been much indication so far that is has been ticking back up toward a target.”

Inflation measured by the PCE (personal consumption expenditure) price index, which is the Fed’s preferred gauge, is around half the level of the U.S. central bank’s 2 percent target. Because of this, he added that “[t]he committee still needs to see more data on the macroeconomic performance for the second half of 2013 before making a judgment on this matter.” The Fed will review developments in the labor market, where unemployment has indeed declined since the latest bond purchase program began last September.

Finally, he said that the Fed will review growth, which has “not been so great” over the last three quarters, in addition to closely scrutinizing the evidence on inflation as just described, which he said was an issue of credibility for the central bank.

Those who believe that the economy is, in fact, doing better got some encouragement from a gauge of U.S. consumer spending last month that rose at its fastest rate in seven months. In addition, small business optimism improved in July as well and last month’s gain in core retail sales was the largest since December, and this was also detailed in a recent issue of this column.

What all of this means is that the debate over whether to start tapering or not is going to dominate market thinking until the next Fed meeting on September 18, and investors might get a preview of the central bank’s latest thinking about this matter today when the minutes of the last F.O.M.C. meeting of July 31 are released at 2 p.m. Naturally, all sorts of Fed watchers and other various pundits and authorities will use the statement to pontificate how what they say will give everyone the “real” insight as to what is going to take place at next month’s meeting, and the answer is that no one really knows what will occur on that date despite what any one individual thinks they know. But stay tuned for sure!


 

Donald Selkin is the Chief Market Strategist at National Securities in New York, a veteran in the securities industry for 36 years who is widely quoted in the financial media.
If you have any questions, contact dselkin@nationalsecurities.com .