Stocks Set to Retest Lows (9/08)

The stock market turned in modest gains in August, yet the major indices remain decidedly negative for the year with the Dow Jones Industrial Average, S&P 500 Composite and NASDAQ Composite down 12.97%, 12.64% and 10.75% respectively through the end of last month. Despite several pieces of surprisingly positive economic input, investors turned their attention once again to failing financial institutions. With the bailout of Fannie and Freddie and Lehman Brothers looking for a suitor, the markets began the month of September on a sour note and seem destined to test the July lows.

While the election-year media seems bent on convincing us that we are in dire economic straits, second quarter GDP was revised upward to a 3.3% annual rate, up from the original estimate of 1.9%. The only negative component of GDP was (predictably) residential construction, as consumer spending, government spending, business investment and especially exports added to the quarterly economic gains. As the rate of decline in the housing market slows, the GDP impact of declining residential construction continues to diminish and should prove even less significant in the coming quarters. Underlying trends suggest that third quarter GDP could be as high as 3%.

Much attention has been given to the recent jobs report that showed a decline in payrolls for the eighth straight month and a spike in unemployment to 6.1%, the highest level since September 2003. As bad as the headlines sound, it is important to maintain perspective. The fact is that payrolls have declined by only .8% since the end of 2007 – that’s less than half the decline witnessed during the economic slump between 2000 and 2002.

Despite a weakening labor market, worker productivity soared by 4.3% in the second quarter, a full 1% higher than the consensus forecast and well ahead of the 2.6% rate of increase in the first quarter and 1.7% rate for all of 2007. Strong output for every hour of work helps explain how the U.S. economy has been able to maintain steady growth in the wake of turbulent times. Meanwhile, the Labor Department also reported that labor costs fell .5% during the second quarter. The combination of rising productivity and falling labor costs is disinflationary and will help the Federal Reserve keep interests stable for the foreseeable future. Indeed, the Fed Funds futures market now predicts a zero percent chance of any rate hike for the rest of the year, offering more time for previous rate cuts to take hold.

Perhaps the most significant economic news is the continued collapse of commodity prices. Not only is the price of oil down nearly 33% from its recent high, natural gas is down 45% and corn, wheat and other food commodities are down over 30% from their recent high. Even the national average price of gasoline has fallen from $4.07 in June to $3.75 per gallon in August and is now below the average $3.80 per gallon seen in May. It seems more evident by the day that commodity prices were in a bubble or mania phase and are now self-correcting that massive excess. Falling food and energy prices, combined with rising productivity and lower labor costs, will dramatically reduce inflation pressures over the coming months. Inflation is the cruelest tax of all and its diminished impact will benefit consumers and corporate earnings alike.

Meanwhile, industrial production rose .2% in July, durable goods orders increased 1.3% in July and showed record-high unfilled orders, the ISM Service Index grew unexpectedly in August and August same-store retail sales rose 1.7%. There is no doubt that the U.S. economy is in the midst of a persistent slowdown, yet the economic data and facts simply do not support the worst-case scenarios presented so often by the media.

The stock market is in the process of retesting the lows placed in mid July, a typical part of the painful, yet necessary bottoming process. Valuations are as attractive as they have been in over a decade, interest rates remain moderate, inflation and inflation expectations are turning down and the economy has stubbornly resisted recession-like trends. Filtering through all the noise, we believe that the surprise will be to the upside.