Don’s Outlook 8/13/2010
Last week’s seesaw market action turned into an outright slide this week as stocks remain stuck in this summer’s range, trading only slightly higher than May’s low but well above the lows of June and July. The excessive pessimism that forced stocks from their April highs has receded, however, as better-than-expected earnings and mixed economic data has analysts and investors assessing the prospects for future growth. In spite of solid valuations, macroeconomic uncertainty was one reason for limiting stocks to range-bound trading.
Investors received some insight to U.S. macroeconomic policy this week when the Federal Reserve met to discuss its own economic outlook and determine the appropriate policy mix moving forward. In the end, the Fed’s action matched the consensus view that it would leave its benchmark interest rate unchanged, but the FOMC did announce that it was prepared to reinvest maturing holdings of Agency and Agency mortgage-backed securities of 2- to 10-year bonds. Although it did not commit to this program or outline a time frame, the announcement opens the door to reverse the process of shrinking the Fed’s balance sheet, which would have caused a gradual tightening of policy. This provides a means to keep mortgage rates low, thereby supporting housing and the economy.
Other key data this week included a higher sentiment reading and a potential inflection point for inflation. The University of Michigan consumer sentiment index rose to 69.6 in August from 67.8 during the prior month, showing gains in the expectations component. Meanwhile, the consumer price index (CPI) rose in July, reflecting a swing in energy prices. Some of the factors that have led to a decline in CPI over the past two months have probably abated. Food, for example, is likely to rise in coming months as the price of wheat continues to escalate from a drought in Russia. Finally, the trade deficit in June widened sharply due to higher import levels. This, along with other weaker data such as construction and inventories, may lead to a revised gross domestic product number for the second quarter.
So, in spite of the fact that stocks look rather cheap at a P/E of approximately 12 compared to their long-term average multiple of 14, a disconnect remains in the eyes of many investors due to changing perceptions. As long as economic data is softening, investors are likely to discount the current earnings season because they are skeptical about future earnings. Moreover, in spite of robust results—with a large percentage of companies beating expectations—analysts are reluctant to extrapolate into successive quarters, even though guidance remained healthy. This has occurred in the past two quarters by the way, possibly setting the stage for another solid earnings picture for the third quarter and higher valuations.
