Weekly markets commentary – September 28, 2009

David Joy — Chief Market Strategist, RiverSource Investments

Economic weakness sparks selloff

Stocks pushed lower last week after some soft economic data and ongoing concerns that valuations have become stretched. The S&P 500 Index fell 2.2 percent, a worse performance than both the Nasdaq Composite Index and the Dow Jones Industrial Index, which declined 2.0 and 1.6 percent respectively. Mid cap and small cap stocks fell even further.

Not surprisingly, it was the more economically-sensitive sectors that absorbed the brunt of the selling. Energy, industrials, consumer cyclicals and materials stocks all fell more than the broad index. Technology was a notable exception, falling less than the overall market. Joining tech in the "best among a bad lot" category were staples, financials (with some notable exceptions), utilities and telecomm.

Consistent with the weaker tone in equities was some muted strength in the dollar, a decline in both gold and crude oil prices and a slight rise in the Chicago Board Options Exchange (CBOE) Volatility Index (VIX).

Economic reports disappoint

Two data reports last week allowed concerns regarding the strength and sustainability of the nascent recovery to take center stage. The first was a 2.7 percent decline in existing home sales in August. Sales remained 3.4 percent ahead of last year, but the decline was a reminder that the pace of recovery may be uneven. New home sales rose by a sluggish 0.7 percent, but only from a downwardly revised July total, and remained 4.3 percent below the pace of a year ago.

The second disappointment came from the durable goods report, which showed orders down 2.4 percent in August, led by a steep contraction in aircraft orders. Although the durable goods report (which can be volatile) followed a strong July, it was below expectations and only served to reinforce the same concerns raised by the housing reports.

The week ahead

The economy will once again command attention this week. The September jobs report will be released on Friday. It is expected to show a decline of approximately 175,000 non-farm jobs, continuing the improving trend that has been in place for several months.

Before then, the national Institute of Supply Management report on Thursday is expected to rise once again, reinforcing the recovery in manufacturing.

Also on the calendar is the S&P/Case-Shiller home price index for July, itself expected to show another modest rise. August reports on personal income and spending, and factory orders are scheduled as well.

Lastly, on Thursday the report on September vehicle sales will be released. An inevitable retreat from the 14 million unit annualized pace of sales in August is certain, but to what rate is unknown. During the first six months of the year sales ran at a nine million annualized pace, and then spiked in response to the "cash for clunkers" program. While nine million is considered by many to be unsustainably low, 14 million is unsustainably high. Where the equilibrium level is may remain unknown for several more months as the distortion of the clunkers program washes through the system. Inventory levels remain very light as managements remain cautious. But expectations are that sales will move higher over time and production will follow. How high is an open question.

Third-quarter earnings

As the third quarter comes to an end on Wednesday, attention will soon turn to third-quarter earnings. They could once prove to be better than expected, although still lower than the third quarter of last year. A lingering issue concerns the delivery of better earnings through cost cutting. Certainly, cost cutting is the appropriate response by management to a difficult operating environment. But managements, as well as investors, understand that eventually sales growth will be necessary to sustain higher equity prices. The third quarter may still qualify as a grace period for managements, since revenue growth may have remained difficult to achieve. Eventually, this tolerance will expire, but let's hope not too soon.