Weekly markets commentary – October 5, 2009

David Joy — Chief Market Strategist, RiverSource Investments

Doubts on strength of recovery send stocks lower

Stocks fell for the second week in a row as questions persisted about the strength of the economic recovery. Two weeks ago, reports on home sales and durable goods orders disappointed. Last week, the manufacturing sector and the labor market reported softer-than-expected conditions.

With last week's decline, the S&P 500 Index is now 4.3 percent below its recent closing high of 1,071.66 on September 22. Most of last week’s damage came on Thursday, after the Institute of Supply Management (ISM) index for September showed some moderation from August. There was also some late selling ahead of the September employment report, released Friday, which also showed deterioration from August.

While stocks were falling, bond prices were rising. The 10-year Treasury note yield slipped 10 basis points to 3.22 percent after falling to 3.18 percent on Thursday, its lowest level since mid-May. The two-year note yield fell 12 basis points to 0.87 percent, its lowest since May as well.

The weakness in stocks and demand for bonds reflected the recent strength of the dollar, which also rose last week. Perhaps not so coincidentally, the dollar's recent rally began on September 22, the day stocks began to falter. From that day, the U.S. Dollar Index (DXY) is only 1.1 percent higher, but it has at least temporarily put the brakes on its decline. Back in the summer, between mid-June and mid-July, the dollar also entered a period of relative price stability which coincided with a period of weakness in stocks. Stocks subsequently resumed their rally as the dollar resumed its decline.

Encouraging signs overlooked

Judging from the suddenly dire tone among market commentators in reaction to these data points, one could be forgiven for thinking that the economic recovery had taken a sudden turn for the worse. On the contrary, the data was only mildly worse than expected, and both reports were better than any previous month during the recovery excluding August. In fact, the ISM report showed that the manufacturing sector expanded for the second consecutive month, the only months it has expanded since January 2008. And, while jobs were still lost, the September employment report showed that the rate of job loss was one-third the rate of January, and one-half the rate of April.

Somewhat overlooked were two reports that did show improvement. The S&P/Case-Shiller Home Price index rose for the third consecutive month in July, for a cumulative increase of 3.6 percent, leaving prices at their August 2003 level and 30 percent below their July 2006 peak. And, second-quarter gross domestic product (GDP) was revised to an annualized rate of decline of 0.7 percent from the previous estimate of negative 1.0 percent.

Perhaps the best and the worst that can be said about the latest round of economic data is that it suggests the recovery is clearly underway, but that its trajectory remains uncertain. The first estimate of third-quarter GDP is scheduled for release on October 29, with estimates clustered around a growth rate of 2.5 to 3.0 percent.

The week ahead

The economy will take a back seat to earnings this week. We will see the September ISM report for non-manufacturing on Monday and it is expected to have expanded for the first time since September 2008. After that, earnings season will dominate the market's attention beginning on Wednesday when Alcoa reports.

If the path of recovery turns out to be slower than may have been hoped, then the pressure increases on earnings to justify current valuations. And there seems to be some complacency that earnings will be better than consensus, possibly setting up the market for disappointment. Conversely, and in the markets favor, the ratio of positive to negative earnings pre-announcements indicates a good earnings season overall.