Weak economic growth contributes to fed consternation

Equity markets closed out the month of October in subdued fashion as investor’s awaited resolution surrounding the elections on Tuesday and the possibility of further monetary easing from the Federal Reserve.  The S&P 500 was virtually flat for the week and the Dow Jones Industrial Average fell a mere 0.1%.  Both indices added more than 3% for the month of October. 

Source: Econoday

 

The notion that economic growth is weakening received some validation last week.

It was announced on Friday that the economy grew at a 2.0% annual rate in the third quarter.  The relatively tepid rate was the result of higher personal consumption and additional inventory restocking.  On the plus side, personal consumption increased by 2.6% in the quarter but the 1.4% contribution to GDP from inventories could be troubling.  Inventories are likely higher on the belief that the recovery is accelerating; however, unless consumer demand keeps pace with inventory growth, inventories will become a drag on the economy in the coming quarters. 

 

Source: Federal Reserve Bank of Cleveland

 

Despite President Obama’s promise to double export growth by 2015, exports only grew at a 5% rate in the quarter, far below the 17% increase in imports. 

 

The other bit of modestly positive data came in the form of existing home sales, which rose 10% to 4.53mln on a seasonally-adjusted annual rate.  Despite the positive pop, sales are roughly 19% below the rate during the same period in the prior year.  Complicating the problem is the near 11 month overhang of housing supply based on the current rate of sales.  This does not even account for the “shadow” housing inventory of foreclosed and bank-owned properties that have yet to be listed for sale.  

 

Source: Econoday

 

One of the first signs that the Federal Reserve is engaging in a dangerous game of investor roulette emerged at the start of last week when the Treasury sold $10bln of 5-yr Treasury Inflation-Protected Securities with a negative 0.55% yield.  Investors are making an explicit bet on the Fed’s ability to reignite inflation through the use of asset purchases. 

 

Source: Wall Street Journal

 

TIPs’ auctions are gaining in prominence due to heightened awareness about the possibility of inflation.  Some research firms believe the Treasury will auction north of $100bln worth of TIPs next year.  That would represent the largest dollar amount of auctions on record. 

 

With elections right around the corner, a number of polling services are releasing rather interesting data on voter dissatisfaction.  A recent telephone survey from Rasmussen Reports found that 65% of US voters would prefer to fire every member of Congress and start fresh.  Unfortunately, that is not a possibility, but it shows just how disenfranchised the voting populace in this country has become.  

 

Is market sentiment sending up a yellow flag?

Investors are wondering whether the recent market rally is built on a solid foundation or merely another in a long line of illusionary rallies should heed a bit of caution.  Investors are largely bidding risk assets higher on the belief that the Federal Reserve will inject significant amounts of liquidity into the economy through a second round of asset purchases.  This is an extremely dangerous and poor investment thesis.

 

There are several reasons in particular why investors should exhibit caution.  The first is equity fund flows.  In the week ending October 20th, retail investors contributed $2bln to equity mutual funds, this following additions of $762mln in the week prior.  While the absolute amount is small, it represents the first such contributions since April, just prior to the market correction centered on the sovereign debt crisis.  Retail investors have hardly done themselves any favors when it comes to timing the equity markets.

 

Second, the ratio of bullish to bearish investors, as measured by the American Association of Individual Investors, is at the highest point since February 2007.  For the week ending October 28th, 51% of individual investors were bullish on the outlook for equity markets and 22% were bearish.  Such extreme sentiment readings are a common occurrence around inflection points in the market.   

 

Source: Bespoke Investment Group

 

At the same time, institutional investors are moving in the opposite direction and becoming increasingly bearish.  Based on the most recent Investor Confidence Index from State Street, global confidence fell from 88.1 to 86.2.  The index is compiled based on the actual buying and selling habits of institutional investors.   

 

Source: State Street

 

There is truth to the notion that the Fed will stimulate the economy, and by extension the markets, into a new stratosphere, however, much of that is already priced into stock valuations.  Investors should remain cognizant of the possibility for a pullback, or at least a pause, in the push for high risk asset prices.  

 

The week ahead

There is no rest for the weary, as the upcoming week brings a flurry of political, economic and corporate news. 

 

The elections on Tuesday will be a focal point for the markets.  As of Sunday evening, the website Real Clear Politics projected Republicans to win the House of Representatives, but the race for the Senate remains very much undecided. 

On Tuesday and Wednesday, the Federal Open Market Committee will meet in Washington to decide whether recent economic data warrants further quantitative easing.  Various research firms are expecting the Fed to announce up to $100bln per month of asset purchases. 

 

In addition, central banks in Australia, Japan, England and the European Union will meet throughout the week. 

 

Not to be forgotten, the October employment report will be released on Friday.  Private sector payrolls are expected to grow at a very modest rate for the month, while the unemployment rate is likely to remain at 9.6%.  Other economic releases of note this week are the ISM Manufacturing report on Monday and consumer credit on Friday afternoon.  

 

Chinese President Hu Jintao will visit France on Thursday with the inevitable discussion of currency revaluation likely to take center stage.  Finance ministers from the Asia-Pacific Economic Co-operation (APEC) assemble in Kyoto, Japan beginning on Friday for several days of meetings.  On Saturday, President Obama travels to India for four days of discussions with Indian Prime Minister Manmohan Singh. 

 

Earnings reports will play second fiddle to the elections and Federal Reserve, although, a host of important companies will report during the week.  Included on that list are Berkshire Hathaway, Archer Daniels Midland, BP, Kellogg, Pfizer, Anheuser-Busch InBev, Alcatel Lucent, BNP Paribas, Kraft, Nissan and Toyota.  The earnings per share beat rate by day this earnings season is settling right around the 70% rate, which is quite strong.

 

Source: Bespoke Investment Group

 

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