Sunday, May 21, 2006

Weekly Recap

The market went from looking at everything in a positive light to looking at everything in a negative light in a couple of weeks. The week ended May 12, the S&P dropped 34.52 points (2.6%). The catalyst was the Fed policy statement, which did not indicate that the Fed was done raising rates.

This week, the S&P dropped 24.21 points (1.9%). The catalyst was a single extra 0.1% on an inflation measure. On Wednesday, it was reported that April core CPI (total consumer inflation excluding energy and food) was up 0.3%. A gain of 0.2% had been expected. The slight miss led the S&P to plunge 22 points that day. No one is arguing that inflation is picking up sharply, but even a slight uptrend is considered dangerous to the financial markets at this time.

This was the second straight monthly increase in the core CPI of 0.3% and it pushed the year-over-year increase in this measure to 2.3% in April from 2.1% in March. That is above the Fed's forecast of 1 3/4% to 2% for core inflation for all of 2006. It is therefore assumed to be higher than the Fed will tolerate. If the core CPI continues to firm, there will be fears that the Fed will have to raise rates further to curtail demand, even if that means slowing down the economy significantly.

That puts second half of the year earnings forecasts at risk. Current estimates are for over 10% earnings growth. But the market action suggests that investors are questioning whether that can occur.

Everything negative gets play now. The weak dollar is perceived as a negative for stocks. Anything remotely inflationary gets top billing. Earnings estimates are in question. Weak economic releases create anxiety about the state of the economy. There is even talk that a correction of 10% could be in the offing.

Just a few weeks ago, the conventional wisdom was that interest rates were peaking soon enough to allow economic and earnings growth to continue strong. The fashion in the market has changed completely.

The market may in fact continue to struggle in the weeks ahead. The "sell in May and go away" seasonal factor can be self-fulfilling. The market has historically struggled over the summer months and that can create caution.

Money market rates are also a factor. Investors can now get 5% or more from CDs. The S&P is up just 1% so far this year and was up 3% last year. Those safe money market yields will appeal to skittish investors.

It is not all bleak, however. The price/earnings ratio for the S&P 500 in aggregate for operating earnings is only 15.8. The price/earnings ratio on as-reported earnings is 17.4. Those are very reasonable considering that economic momentum is still good. Real GDP and earnings growth are slowing, but not ending.

The other news this past week had little influence once the CPI data shifted underlying sentiment, even though much of it was upbeat. Oil prices declined to end the week at $69.29 a barrel. The yield on the 10-year note dropped to 5.04% from 5.18% at the end of the prior week.

The April core PPI was up a less than expected 0.1%. Other economic releases leaned bullish as well. Housing starts were down, but industrial production was up a strong 0.8% for April, and May surveys showed manufacturing remained strong this month.

Earnings reports were mixed. Wal-Mart and Home Depot had decent reports, but there are concerns about the outlook for consumer spending given high gas prices. Deere and Hewlett-Packard had good reports. Dell came in as they said they would after a recent warning announcement.

The market will be keyed to any and all inflation indicators in the weeks ahead. Economic data will be important. Over the short term, however, the psychological factors are critical. The market is looking to find a bottom so that the heavy pessimism wears off, just as the optimism of a few weeks ago did. The sell-off the past two weeks is warranted as an adjustment to the realization that the Fed will raise rates further and that there are some inflationary pressures.

The reality, however, is that the fed funds futures are still only priced for one more rate hike, and that the core CPI was only up 0.1% more than expected. Inflation isn't surging. It was another very bad week, but the fundamentals haven't tanked as much as market sentiment.



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