Weekly markets commentary – November 2, 2009

David Joy — Chief Market Strategist, RiverSource Investments

Curious market behavior

Judging from the two-day volatility in stock prices following the release of the advance estimate of third quarter U.S. gross domestic product (GDP), one would think it was full of surprises. This was hardly the case. In fact, the principal surprise was that growth was stronger than expected. But over the ensuing two days, the Dow Jones Industrial Average lost 50 points, or 0.5 percent. After initially climbing 200 points on Thursday, the index dropped 250 points on Friday. The S&P 500 Index traced a similar percentage path.

As the old saying goes, the market is always right. In other words, the numbers are the numbers and we all have to deal with them. But the reaction to the GDP report seems a little out of synch.

Some would argue that stocks arrived at their rightful level by week's end because the GDP report was juiced by government stimulus. They might deduce that without government stimulus, the GDP number would have been much lower, and only after a more thoughtful examination of the contributions to growth did the market come to its senses and wash out the initial euphoric reaction to the headline number and close lower on balance.

But didn't we already know that the third quarter had relied in large measure on government largesse? Didn't we know that the "cash for clunkers" program had boosted consumer spending and that the first time home buyer tax credit boosted home sales and, by extension, housing starts? Wasn't it expected that a slower rate of inventory liquidation was likely after precipitous declines in the previous two quarters?

Of course we knew all this, and yet the market reacted as if it was all a surprise. One could just as easily conclude that the real surprise was how effective the various stimulus programs seemed to work. After all, the consensus expectation for the quarter was 3.2 percent growth, below the 3.5 percent result.

However, the issue of final demand continues to dominate the discussion of the eventual shape of this recovery. The third quarter report did nothing to allay the fears that neither the consumer nor the business sector are either willing or able to start spending and be in position to accept the baton of growth when it is eventually passed by the hand of government.

But we knew that going into Thursday's report. The GDP report was not expected to allay those fears. It was not expected to show much underlying private sector demand. For the market to react as it did, betrayed a sense that hope springs eternal — a sense that despite what we know, maybe we'll get lucky and the underlying strength of the economy will be better than expected. That didn't happen. Then again, it wasn't expected to.

That private demand wasn’t stronger than hoped does raise the stakes going forward. Every new quarter that passes gets us closer to the end of the stimulus and to a point in time when the private sector darn well better be ready to accept the baton. Otherwise, the strength and sustainability of the expansion will be increasingly called into question.

Last week, the Chicago Board Options Exchange (CBOE) Volatility Index (VIX) jumped 8.4 points, or 38 percent. This week's economic calendar is full of enough important releases to keep the market on edge once again.

The week ahead

Dominating investor attention will be the Federal Reserve's decision on Wednesday, followed by the October employment report on Friday. While the Fed is widely expected to say little different from its recent statements that it intends to keep policy accommodative for an extended period, the exact wording will be parsed carefully for any hint of a future change in direction.

The employment report is expected to show the loss of approximately 175,000 non-farm jobs, an appreciable improvement over the negative 263,000 September report. It would be the smallest monthly decline since last October if realized.

Already this week, we have learned that the U.S. manufacturing sector expanded in October, at a much faster rate than anticipated. The Institute of Supply Management (ISM) index jumped 3.1 points to 55.7 versus an expected reading of 53. And for September, both construction spending and pending home sales were surprisingly robust.

Later in the week, we get reports on domestic light vehicle sales for October, which are expected to show a modest increase from September. After the distortion of sales numbers from the "cash for clunkers" program in the July-September period, the October data will provide a cleaner look at underlying demand. The ISM non-manufacturing sector survey is expected to have moved incrementally higher as well. Lastly, both wholesale inventories and consumer credit reports for September are expected to show another month of contraction.