Weekly Recap

It was a wild ride for the stock market this past week. The focus was on inflation and the Fed.

Early in the week, the market tanked on fears over inflation. Then, on Wednesday when the inflation news did in fact turn out to be worse than expected, the market rallied. The rally continued strongly on Thursday, but faded on Friday. Throughout all this, Fed officials made numerous statements on inflation. Most of them were hawkish.

The action this past week was subject to sharp swings in sentiment. Fear took hold early in the week. Later, once the news hit, and the market didn't drop further, latent demand emerged. Talk that the market had reached a bottom emerged and the focus shifted to a longer-term, more optimistic outlook. For investors, it was a week to ignore the daily chatter and rapid mood swings, and to sit back and assess the longer-term prospects.

The key news, of course, was the May core CPI data on Wednesday. It posted a third straight 0.3% increase. The rate of increase in the core rate the past three months was a worrisome 3.8% and the year-over-year increase in the core rate rose to 2.4%. The trend in the core rate is clearly unacceptable to the Federal Reserve. Fed funds rate futures quickly priced in a near certainty that the Fed would raise rates at the June 29 meeting, and a good chance of a further rate hike after that.

Numerous Fed officials expressed concern about the trend in inflation. However, the market took solace from comments from Fed Chairman Bernanke on Thursday that the Fed expected to control long-term inflationary expectations.

The market apparently had priced in bad news, and once it hit, adopted a more sober assessment of the long-term outlook, helped by Bernanke. The reality is that the Fed will indeed have to raise rates further, but that economic growth will remain decent. That means that earnings growth in the second half of the year will also be decent. The economy is slowing, and that will eventually lead to lower inflation rates. The outlook is worse than it was a few months ago, but it is not bleak. And with the S&P 500 index now trading at under 16 times operating earnings, valuations are good.

The market is thus caught between the fears of the Fed going too far, and the realization that there is still fundamentals demand for stocks. That is leading to a high level of volatility.

The other news this week took backstage. Core PPI was up 0.3% and total PPI 0.2%. May retail sales rose just 0.1%, reflecting a softening in consumer demand. May industrial production dipped 0.1% after two big increases. Several brokers (Lehman Brothers, Goldman Sachs, and Bear Stearns) reported great earnings. Adobe Systems had a mixed earnings report, but Oracle raised estimates for the current quarter.

Oil prices dropped to under $70 a barrel from $72 last week as tensions with Iran eased a bit. The 10-year note yield, however, backed up to 5.09% from 4.98% over inflation worries.
None of this news made much difference as the market sorted out its concerns about inflation and the Fed.

The market may continue to be subject to severe volatility as any bad news on inflation could stoke the worst fears. The fundamentals aren't that bad, however, for the long-term. But until the market gets a cleared sense of the outlook for inflation and Fed policy, the prospects of a significant summer rally seem remote.

-- Briefing.com