Daily Insight

The S&P 500 posted its first weekly loss in five weeks as an unexpected drop in consumer confidence pushed equity markets lower on Friday. The weaker consumer confidence reading added to concerns that the fastest rally since 1938 has lifted stock valuations too far, too fast – the S&P 500 is currently valued at 18.5 times earnings, the highest level since December 2004. Because consumer spending accounts for about 70% of GDP, a sustainable recovery will be difficult if the consumer remains in the fetal position.

All ten sectors in the S&P 500 declined led by the inflation-sensitive materials, industrials, and energy sectors following reports that the cost of living in the U.S. was unchanged in July. Consumer discretionary shares also faced stiff pressure thanks to the disappointing consumer confidence reading that followed poor retail sales figures the day before.

Market Activity for August 14, 2009
Industrial Production
Industrial production rose for the first time since October 2008, primarily due to the cash for clunkers program which has helped the auto industry recover from sever production cutbacks earlier in the year. Still, excluding motor vehicles and parts, manufacturing climbed 0.2%. As a result of the increase, capacity utilization improved to 68.5% after touching a record-low 68.1% in June. As we have said many times before, depleted inventory levels make an eventual pickup in industrial production inevitable and this is one of the reasons many expect GDP will turn positive in the second half of the year.

Capacity rates gauge factories’ ability to produce goods with existing resources – lower rates reduce the risk of bottlenecks that can force prices higher. The average economy-wide capacity utilization rate in the U.S. since 1967 is about 81.6% according to the Federal Reserve. Rates between 82% and 85% signal price inflation will increase. At 68.5%, the capacity utilization rate does not support the argument that we are currently in an inflationary environment just yet, nor did the Consumer Price Index (CPI) reading.

Consumer Price Index (CPI)

The CPI index was unchanged in July, which matched expectations. The core rate, which excludes food and energy prices, rose just 0.1%. When compared with the same period last year, prices continue to show a deflationary trend – mainly due to the sharp fall in energy prices – as the headline rate fell 2.1%, but the core rate was up 1.5%. As a result, Ben Bernanke and company can put off addressing the weak dollar and inflation for the next few meetings. As long as inflation is restrained, the Fed can take its time in unwinding stimulus, without pressure to act before it feels the economy is ready to stand on its own.

Of course, it is important to note that the inflation data benefited from over a 50% decline in the price of oil compared to last year, and the August data will similarly enjoy a 35% decline in the CRB Index (the widely used benchmark for commodity prices) from a year ago. However, if we assume today’s prices, come December the CRB Index will be up 26%, and the price of oil will be up 100% come Christmas! How important are commodity prices in the CPI calculation? According to the Bureau of Labor Statistics, the relative importance of commodities in the CPI index is 39.5%.

As you can see, inflation will become a bigger concern in late 2009 and early 2010, at which point the Fed will need to decide to either defend the dollar or allow inflation to rise above their target level of 2%. Raising rates would provide a real rate of return for savers, but could short-circuit this recovery. On the other hand, keeping rates low will allow the economy to grow, but will cause inflation and fuel America’s debt addiction. Both scenarios are unpleasant.

Monday morning futures are down
Futures on the Dow Jones Industrial Average are down 190 points as I type on concerns that stocks have gotten a bit ahead of themselves (echoing concerns I raised in last Monday’s post). The credit crisis left our financial system crippled and the government has taken on trillions in debt which will threaten the economy with inflation and higher tax rates. Meanwhile, recent economic data is showing that the consumer is not ready to spend as they contend with weak income growth and balance sheet issues.

A pullback is no real surprise at this point and is certainly no reason to panic. Most pullbacks since March have been short-lived as investors on the sidelines view the declines as an opportunity to buy in. There is no way to tell whether this trend will continue, so a patience and disciplined approach to investing remains essential.


Have a great day!


Peter J. Lazaroff, Investment Analyst