After beginning Friday’s session higher, the major indices saw those early gains evaporate again to close lower.  This was even without an economic data release, which has been what’s sending traders running for cover lately. 

For the week, the broad market shed 4.69%, marking the fourth-straight week of decline.  At less than four points above the prior week’s low on the S&P 500 (hit Wednesday August 10), the broad market is nearly 18% off the three-year high hit on April 29.

The best-performing sectors naturally remained the traditional areas of safety as health-care, consumer staples and utilities handily beat the market – but all three did close lower for the session. Tech, financials and energy took the heaviest beating – financials are down 23.6% YTD and nearly 30% from the 2 ½ year high the group hit in February.

U.S. stock futures are following European bourses, which are nicely higher, this morning.  We have the Fed Chairman’s annual speech from Jackson Hole on Friday and as we all recall it was at last year’s event in which Mr. Bernanke signaled QE2 was coming, the expectation is that he’ll express some market-enhancing words this go around too. 

With the Libyan rebels all but ousting Gaddafi as they entered the heart of Tripoli yesterday, many people came in this morning expecting crude to plunge, specifically Brent as European crude trades more sensitive to events in Africa (although I don’t understand this logic as it is neither certain the rebels will manage production properly nor a given the next regime that pops up will be any less radical than Gaddafi).  Brent is down just 1.1% to $107.40/bbl and WTI (West Texas Intermediate) is up 1.3% to $83.50/bbl.

Market Activity for August 19, 2011

Sector Activity for August 19, 2011

The Profit Cycle and Valuation

Wall Street analysts and equity-market strategist are beginning to come to grips with something we’ve talked about in this letter for some time now:   There was something wrong with valuations.  Even as they appear to be very cheap right here at roughly 12 times earnings – and even at the April 29 peak the valuation was a reasonable 15-16 times – doubt about the denominator in that P/E ratio is setting in. 

Currently, we’re at peak earnings (peak of the cycle thus far) and valuing the market on this basis is dangerous, as we found out in 2007 when the S&P 500 traded at a seemingly mild 17 times.  But at the current level of S&P 500 earning per share, the figure is more than 50% above the 10-year cyclically-adjusted number of $58/share – a situation that has occurred only two times to my knowledge, in 2000 and again in 2007.  The point is the current level is unsustainable, particularly as economic growth grinds to a halt and the profit cycle has been very much enabled by massive cost cuts via payrolls. 

I’m not sure the market will get back to what the 10-year cyclically-adjusted earnings analysis would say is fair value (950 on the S&P 500) this go around.  We have a Fed that is intensely focused on buoying the equity market, and even though we’ve got a state of Fed limbo right now traders will expect something big is coming.  But one should be mentally prepared for the market to return to that fair value level that puts the market at 15 times cyclically-adjusted earnings. 

This Week

We were without an economic data release on Friday, but this week we’ll be watching some big results. 

On Monday, we start the week off with the Chicago Fed’s National Activity Index for July.  The number to watch is -0.70 on their three-month average, which is the level the Chicago Fed says suggests we’re back in recession.  Economists expect the monthly reading to come in at -0.48, we’d need a reading of -1.10 to get that three-month average to the troubled -0.70 mark.  Based upon the degree to which analysts have missed expectations lately, while such a move is unlikely, it’s hardly out of question. 

On Tuesday, the focus will turn to the Richmond Fed index, especially after the prints Empire and Philly have delivered, as the market watches to see if we get another negative reading from the regional factory reports – which would mark the first time we’ve had three reports print negative readings for a given month since early 2009. 

On Wednesday, durable goods orders for July will be the figure to watch as we see if orders rebounded from the 1.9% decline in June.  Beyond the headline reading, we’ll have to see the business-spending proxy within the report post an increase after posting weak results on net year-to-date.  The expectation is for a decline, which would mean this measure of business spending on software and equipment is flat for the year.

On Thursday, we get initial jobless claims, watching to see if we can break meaningfully below the 400K – an unlikely development due to the economic weakness.

On Friday, we get both the first revision to Q2 GDP and the final print for the UofM’s consumer confidence reading for August. 

GDP is expected to be revised down to 1.1% from the 1.3% initially estimated (first-half GDP has been nonexistent at 0.7% and for the past 12 months a paltry 1.5%).  The UofM’s previous confidence reading for August was the lowest since 1980, so hopefully the number isn’t revised any further in the tank. 

Sign up to receive the Daily Insight and other Acropolis publications here.

Have a great day!

Brent Vondera, Senior Analyst