Weekly Markets Commentary – September 2, 2008

David Joy — Chief Market Strategist, RiverSource Investments

For more commentary and insight, visit riversource.com/funds

August Appreciation

Despite a stumble at the finish, stocks managed to rise in August, the first monthly increase since May. The gain for the S&P 500 Index wasn't spectacular, just 1.2 percent.

A selloff in the final two weeks of the month subtracted 1.2 percent from that total, amidst the lightest trading volume of the year. For the final week of the month, volume totaled only 3.7 billion shares. That's about half the average weekly volume of the past year.

At 1283, The S&P 500 is now up 5.6 percent from its 2008 low on July 15. But the index has basically treaded water since August 11, after touching its recent high of 1305.

Oil & Stocks

It is worth noting that the price of oil has traced a similar pattern. After peaking at $145 a barrel on July 14, oil fell to a low of $113 a barrel on August 12. Since then, it too has treaded water and actually drifted somewhat higher as Hurricane Gustav approached, closing at $115 on Friday.

It will be interesting to see whether this tight correlation persists as this week's trading gets underway. Early indications are that this trend will continue.

Stocks in Europe are moving sharply higher in early trading on Tuesday as the impact of Gustav was not as bad as feared. Oil is currently trading at $107.66, almost a seven percent decline from Friday's close and 26 percent below its peak!

Economic Indicators

The revision to second quarter gross domestic product (GDP) was the other big piece of news last week. Originally estimated at 1.9 percent, it turns out that the U.S. economy actually grew at an annualized rate of 3.3 percent.

Most of the revision came from strength in net exports, which contributed 3.1 percent to the overall growth rate. While this is certainly welcome news, it also means that without it the economy would be barely growing.

Two elements of weakness contained in the report are worth noting.

First, businesses liquidated inventories for the third consecutive quarter. This process, which betrays a real sense of caution about the health of the economy, subtracted a substantial 1.4 percent from the annualized growth rate. One could argue that this implies an increase in production down the road, but only if demand is strong enough to justify it. Unfortunately, that is not in our forecast.

The second data point of note is that the drag from the decline in residential construction activity slowed meaningfully. In the second quarter it subtracted 0.6 from the total, but this was roughly only half the level of the prior quarter and the average of the previous three quarters.

There was also a sliver of hope contained in the monthly reports on new and existing home sales, as price declines are enticing some buyers back into the market. However, prices continue to fall in some markets. Nationally, the S&P/Case-Shiller Home Price Index fell again in June, and is now 18.8 percent below its July 2006 peak.

Stocks rallied sharply in response to the GDP revision last Thursday, but immediately reversed direction on Friday after a reported decline in personal income and soft consumer spending in July. While the GDP report was a welcome development, it is old news. The July reports suggest that the effects of the economic stimulus package and its rebate checks are beginning to wane.

Inflation Watch

The news on the inflation front is also somewhat troubling. The core personal consumption expenditure deflator rose 0.3 percent for the second month in a row, sending the trailing 12-month rate to 2.4 percent, the highest rate since February of 2007.

Many, including the Federal Reserve, believe (or hope) that economic sluggishness combined with falling commodity prices will prevent this price measure from rising significantly higher. Unfortunately, this is not our view.

We remain concerned that commodity prices, which remain elevated compared to last year and beyond, combined with an easy money policy will still push inflation higher. The headline rate for July, which includes food and energy prices, rose at a 12-month rate of 4.5 percent, the highest since February 1991.

International developed market equities outperformed their U.S. counterparts last week, climbing 1.8 percent in dollar terms, and 2.3 percent in local currencies.

Given the recent strength in the dollar, the experience for dollar investors in these markets has been less productive than for local currency-based investors.

In local terms, the MSCI EAFE index bottomed out on July 15 (as did the S&P 500). From mid-July through the end of August, the MSCI EAFE is 6.2 percent higher (similar to the S&P 500).

However, in dollar terms, the MSCI EAFE index did not bottom until August 19, as the dollar continued to rise. Since then, the index has gained 3.1 percent, a better result than in the U.S market, as the dollar rally stalled.

In the bond market, the most intriguing development has been the ongoing widening of yield spreads between lower quality bonds and Treasury securities. The 10-year Treasury note closed last week at a yield of 3.81 percent, lower by six basis points on the week. As recently as July 23, the yield was 4.15 percent.

At that time, the spread between the 10-year note and the Merrill Lynch High-Yield Master II index was 763 basis points. Since then, the spread has widened out to its current level of 843 basis points, the highest since late March (during the Bear Stearns crisis). In this same time frame, since July 23 until now, the yield-to-maturity of the high-yield index has risen from 11.12 percent to 11.50 percent.

This development is suggestive of further economic weakness to come, accompanied by rising incidence of default. The question for investors is whether this spread widening has gone too far.

The Week Ahead

This week's economic calendar offers little respite for those trying to ease back into the fray after returning from vacation.

The national Institute of Supply Management report on manufacturing conditions is scheduled for release on Tuesday, and follows a much stronger-than-expected report from the Chicago region last week.

The non-manufacturing report is scheduled for Thursday. Also on that day, we will get second-quarter reports on productivity and unit labor costs, important considerations for inflationary pressure.

On Friday, we get the August employment report which is expected to show another month of job loss in the vicinity of 75,000, with the unemployment rate expected to remain at 5.7 percent.

For now, we remain cautious regarding equity markets in the intermediate term. The uncertainty regarding the future path of the economy and its implications for revenue and earnings growth weighs more heavily on our positioning than arguably attractive valuations. However, value does exist for the long-term investor despite the current uncertainty with many markets sectors having already corrected sharply.