The Stock Market Sells Off on Interest Rate Fears and Overseas Troubles

A combination of fears of the Federal Reserve tightening interest rates sooner than the market had been anticipating and negative events in other countries resulted in the stock market undergoing a vicious correction over the past several days which has brought the S&P to a 3.4 percent decline off its record highs reached in late July. In fact, the selling became so intense last week that this index underwent its largest weekly decline since June 2012 with a loss of 2.7 percent alone.

One could argue that a market that has gone without an official “correction” of 10 percent for 35 months as opposed to such an event taking place an average of every 18 months since 1946 is in need of some sort of cooling off, but the recent declines look overdone considering the fact that second-quarter earnings have come in above consensus and the Federal Reserve as of last week still maintains that policy will remain “accommodative” (read: no rate hikes) for a “long period of time.”

Of course that did not prevent investors from hitting the sell button for a variety of reasons, the first of which was a classic example of the old “good news is bad news” syndrome, as it was reported that first-quarter G.D.P. declined by “only” 2.1 percent as opposed to the last reading of a 2.9 percent drop. Then it was reported that the U.S. economy rebounded sharply in the second quarter as consumers increased their spending and businesses restocked their inventories. The number of 4 percent was much higher than the 2.9 percent consensus of market experts. Despite these better numbers, overall growth in the first half of the year has badly lagged the traditional 2 to 2.5 percent rebound rate, as the nation’s recovery from the worst recession since the 1930s is still the slowest on record.

Consumer spending, which makes up 70 percent of G.D.P., accelerated to a 2.5 percent rate, up from the paltry 1.2 percent level during the first three months of the year. Inventories accounted for 1.7 percent after causing a 1.2 percent decline during the first quarter. The savings rate rose to 5.3 percent from 4.9 percent in the first quarter and this could be a good sign for future spending.

As mentioned above, the market took the good news as bad news in the sense that investors now believed that the Federal Reserve would start raising interest rates sooner next year rather than later. This notion was exacerbated by last Thursday morning’s report of a 0.7 percent quarterly increase in the employment cost index for the second quarter, much greater than the forecast for a 0.5 percent rise and more than twice as much as the first quarter’s 0.3 percent uptick. This was a sign of a better labor market and the potential for some inflationary pressures as a result.

The F.O.M.C. released the minutes of its latest meeting last week as well, and it appeared to be more of the same as they continued with the tapering plans that have reduced their bond purchases down to $25 billion a month with the end of this program scheduled for October. They added that longer-term inflation expectations remained stable as they still see “significant underutilization of labor resources.” The odds of persistent sub-2 percent inflation have been “diminished somewhat” but at the same time they added that housing remains slow and consumer spending has risen only moderately. These comments certainly do not give the impression that interest rate increases have been pushed ahead, but this is not what the bond market was thinking as the yield on the two-year Treasury Note, which is most sensitive to Fed policy, rose to its highest level in three years at 0.56 percent.

Not even a moderate July jobs report could reverse this thinking, as 209,000 positions were created and the unemployment rate ticked up to 6.2 percent due to an increase in the size of the labor force. This was now the sixth straight month of 200,000 plus gains, the longest such streak since 1997.

As if interest-rate worries were not enough, events in both Europe and South America also added to investor anxieties as Portugal’s largest bank sought protection from its creditors and trading in it was suspended. Inventors used this situation to worry that the credit contagion from this situation in addition to Argentina’s bond default, the first country to do so since Greece back in 2010, could spread to other countries as well.

Then we had the ongoing drama in Ukraine, as last week the E.U. announced sanctions which will cut Russia’s access to bank financing and advanced technology and will also restrict their exports of oil equipment. President Obama said that the U.S. will put sanctions on three Russian banks and a state-owned shipbuilder. On Tuesday of this week, the market sold off sharply once again when it was reported by the Polish Foreign Minister that Russia had massed 30,000 troops on the eastern Ukraine border and was prepared to invade.

All these worries are overshadowing the fact that second-quarter earnings are coming in above consensus at a gain of over 8 percent and revenues have risen by more than 4 percent for the 400 S&P companies that have reported their results. The fact that interest rates are moving higher must also be looked at in the context of the fact that they doing it from record lows and are indicative of an economy that is getting better, as for instance it was reported on Tuesday that the July ISM Non-Manufacturing Survey, which covers 80 percent of the economy, rose to its highest level since December 2005.

Since the Fed has given no indication that it is ready to begin tightening, the combination of a better economy, interest rates that are still market supportive and more reasonable stock valuations as a result of the recent selloff means that investors are being given an opportunity by the recent selloff to pick up some stocks at much cheaper prices than they have been in a few months, as the S&P reached its lowest level since May 29 as a result of the recent decline. Finally, it should be remembered that bull markets only end upon the onset of a recession, which is the furthest thing that is going to happen under present or future circumstances.

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.

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