Twenty Years Ago Today

This Friday marks the 20th anniversary of “Black Monday,” which sent the Dow Jones Industrial Average spiraling down 508 points or 23% in a day. The panic was sparked by investors realizing that Fed Chairman Paul Volker was wringing money out of the economy without apparent regard for its near-term health. His aim was to irradiate the prolonged and excessively high inflation of the time. The market drop was the second largest inUS history, second only to the first trading day after shutdown following the outbreak of WWI on 12/12/1914. 

Things are dramatically different today than they were twenty years ago. Exchanges have put measures in place to slow or even halt trading when panics ensue. Inflation then was in the high teens; today it is under 3%. Yes, economic growth is slowing as it was then, but we have a Fed that is ready to reduce rates to prime the pump as needed as contrasted with a Fed that was aggressively raising rates to squeeze out inflation. 

The economic expansion that began in 2001 appears to be slowing to a crawl in the next quarter or two, but still recession is avoidable. Yesterday, the Conference Board released its report leading indicators showing a .3% gain, which forecasts the direction of the economy for the next three months. 

Earnings reports and forecasts have been decidedly negative this week with banks such as CitiBank, BankAmerica, and Wachovia leading the retreat. According to Bloomberg, more than one-third of the 92 financial companies in the S&P 500 have reported third-quarter results as of yesterday. Their profit drop is the biggest since Bloomberg began tracking quarterly earnings growth in the third quarter of 1997. Financial firms account for about 19% of the S&P 500’s value and produced 27% of the index’s profits last quarter. The S&P 500 Financials Index has dropped 9.2% this year. 

Today, the world’s largest maker of bulldozers and dump trucks said they expect a 12% decline in North American machinery and engine sales this year. The worst housing recession in years is the common denominator in all the earnings apologies. The government reported Wednesday that housing starts in theUSplunged more than forecast to a 14-year low in September. The 10.2% decrease to an annual rate of 1.191 million houses started followed a 1.327 million rate the prior month. Building permits fell 7.3 percent to a 1.226 million pace. 

Jobs are being affected in housing and the broader economy as shown by the Labor Department’s report of initial jobless claims. It showed an increase of 28,000 claims to 337,000 in the week that ended Oct. 13th. The less volatile four-week moving average increased to 316,500 from 310,500. Companies are showing reluctance to hire which may further dampen consumer spending – more than two thirds of the economy. 

Inflation appears to be under control according to yesterday’s report of the Consumer Price Index. With the threat of rising prices diminishing, the Federal Reserve policy makers have greater latitude in their interest rate policy. Fed Chairman Ben S. Bernanke this week reiterated that the central bank would “act as needed” to foster sustainable growth along with price stability. He went on to say that “intuition suggests that stronger action by the central bank may be warranted to prevent particularly costly outcomes.” 

Bloomberg reports that Mr. Bernanke also shed more light on the role of risk management in the Fed’s decision last month to lower the target federal-funds rate by a half percentage point, a more aggressive move than most economists on Wall Street had expected. He said, “risk-management considerations also played a role in the decision, given the possibility that the housing correction and tighter credit could presage a broader weakening in economic conditions that would be difficult to arrest.” That justified “doing more sooner” with respect to policy, he said Monday. Financial markets this week have raised the odds of another quarter-point rate cut at the end of this month, as housing and jobless-claims data suggest the economy may be weakening. To the question of uncertainty about the economy Mr. Bernanke today said it “provides a reason for the central bank to strive for predictability and transparency, avoid overreacting to current economic information, and recognize the challenges of making real-time assessments of the sustainable level of real economic activity and employment.” 

Economists believe that the economy will slow, but that it will avoid recession. Analysts estimate that earnings for S&P 500 companies as a whole will rise by 7.4% this year and resume double-digit growth of 12.2% in 2008. The reporting trends are mixed so far. Of the 108 companies reporting, 71 (65.7%) have had positive earnings surprises and 30 (27.8%) have had negative surprises. But overall earnings growth is slowing substantially. Earnings are down .7% for the 108 S&P 500 companies reporting so far compared to a gain of 19.1% for the same group in the first quarter of this year.

There are bright spots in the economy and market. From an earnings standpoint, the leading industries are expected to be Automobiles & Components, Consumer Durables & Apparel, Semiconductors, and Software & Services. The best stock performers during this earnings cycle have been in Oil Production, Telecommunications, Software, Networking, Basic Materials, and Industrial and Office Real Estate.

Over the past few weeks we have remained fully invested, though we have moved toward more conservative positions as warranted in all of our models. We have targeted those industries with the best year-ahead outlooks for earnings growth while avoiding obvious industries affected by the housing and credit morass. If the economy shows further signs of weakening to the point of recession, we will become considerably more conservative in our allocations.