Not a Pretty Picture

Wed, Sep 3, 2008 - 11:00pm

Last week, the Commerce Department announced that U.S. gross domestic product for the second quarter rose by a higher-than-expected 3.3%. But was the number as good as many bulls made out? One way to answer that question is to look at what other economic indicators were doing during earlier periods when GDP was roughly similar to what it was in the latest quarter. As the chart below illustrates, jobless claims, unemployment and inflation rates were generally lower, while employment, manufacturing, housing starts, industrial production, and consumer confidence were generally higher than they are now. Based on what lawyers call a “preponderance of the evidence,” it seems clear that last week’s GDP report had little to do with reality.

Over the past decade, moves in the S&P 500 index have loosely tracked swings in the ratio of the iBoxx high yield bond index relative to the investment grade bond index. Odd as it seems, the relationship makes sense. That is because the iBoxx ratio provides something of a read on economic conditions, risk tolerance levels and available liquidity -- all factors that can influence the appetite and environment for stocks.

Last summer, the relationship between the two measures diverged somewhat. Despite all the turmoil that was taking place in fixed-income markets, equities held up relatively well. But things did not stay that way for long. In recent months, stocks have done a bit of catching-up on the downside. Still, while the disconnect is no longer what it was, the two remain somewhat out-of-synch. Perhaps the stock market sell-off that began this week will bring them closer together?

One method for gauging the relative attractiveness of equities is to look at valuation measures like the price-earnings ratio. Studies have shown that stocks tend to perform best when prices are low relative to earnings and vice versa. Interestingly, despite the fact that the S&P 500 is off more than 20% from its October peak, the market’s multiple has climbed to within spitting distance of its five-year highs. The reason? Earnings have fallen faster than prices. Under the circumstances, it looks like there is still a long way to go before the market can be considered “cheap.”

Although many investors rely exclusively on technical analysis when it comes to making their buying and selling decisions, experience suggests it is a good idea to stay abreast of macroeconomic, geopolitical and other factors that could have a significant impact on prices. Even so, it is hard to believe that new developments could alter the strongly bearish technical picture that is currently shaping up in the Dow Jones Utility Index.

Stocks ended sharply lower, hurt by weakness in banks and other financials after Bill Gross, co-chief investment officer Pacific Investment Management and manager of the world’s largest bond fund, warned that the U.S. must buy assets to forestall a “destructive financial tsunami.” In addition, a breach of key support in the S&P 500 index near the 1260 level triggered stop-loss and chart-related selling.

At the close, the Dow Jones Industrial Average fell 344.65, or 3%, to 11,188.23. The S&P 500 Index shed 37.90, or 3%, to 1,237.08. The Nasdaq Composite Index dropped 74.69, or 3.2%, to 2,259.04.

December gold finished $7.40 lower at $800.80, while the U.S. Dollar index climbed 0.7%. Ten-year Treasury bond yields lost seven basis points to 3.62%.

Michael Panzner

About the Author

Author, Finance Faculty Member
financialarmageddon [at] gmail [dot] com ()
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