Major Stock Indices Ended the Week with Modest Gains, but Not Before Enduring the Highest

In the markets:

Major stock indices ended the week with modest gains, but not before enduring the highest level of volatility in many years. For the week, the Dow Jones Industrial Average closed up +1.1%, but not before traveling almost 1,300 points from peak to trough! The NASDAQ composite gained +2.6% to close at 4828, clawing its way back to positive territory year to date. The S&P 500 gained +0.91% and the SmallCap Russell 2000 gained +0.53%.

International markets followed the U.S. market’s lead in recovering from the steep losses that occurred early in the week. Canada’s TSX gained +2.9%, the United Kingdom’s FTSE was up +0.97%, and Germany’s DAX was up +1.72%. China, on the other hand, did not recover. Though China was able to halt an absolute market crash, the Shanghai stock exchange composite index still declined -7.85% for the week. Japan’s Nikkei index also declined, losing 1.54%.

In commodities, crude oil surged more than +12% on news that Saudi Arabia had invaded Yemen. Early-week strength in gold faded, and gold ended the week down -2.35% to $1132.60 an ounce. Silver also declined, dropping 4.83% to $14.58 an ounce. The industrial metal copper ended the week up 2.18%.

In US economic news, the economy expanded at a +3.7% annual rate in the second quarter, according to the Commerce Department. That smartly beat expectations for an upward revision to 3.2%. Nearly all the details were stronger and pointed to a healthy economy. Business investment led the upward revision with nonresidential investment now seen up +3.2% versus down -0.6%. Intellectual property spending grew the most since 2007. Both consumers and businesses spent more than initially forecast.

Home prices picked up as the S&P/Case-Shiller 20-city Home Price Index ticked down -0.1% in June, but rose +5% versus a year ago. The national average was up +4.5% versus a year ago in June. The hottest cities remain Denver, Dallas, and San Francisco. New home sales jumped to a 507,000 annual pace in July, a +5% gain versus June. Sales are up +26% versus a year ago, and it is the eighth straight month of double-digit yearly gains.

Business economists who are members of the National Association of Business Economists expect the Fed to hike rates before the end of 2015. A large majority, 77% of survey respondents, expect the Fed to hike rates, up from 71% in March. 66% feel that the Fed should take this step.

In a big upside surprise, the Conference Board’s consumer confidence index jumped more than +10 points to 101.5, blowing away expectations of a 94 reading. Consumers’ views of the labor market drove the increase. However, the University of Michigan’s sentiment index fell -1 point to 91.9, missing expectations for a gain. The current conditions gauge fell -2.1 points, but the overall U of M index remains up a strong +11.4% versus a year ago.

US durable goods orders jumped +2% in July, when analysts had been expecting a -0.4% decline. Orders remain nearly -20% lower versus last year, but analysts cite a large air show order as skewing last year’s data. Excluding transportation, July orders were up +0.6%, also beating expectations. Core capital goods, which gauge business investment, rose a strong +2.2% in July - the second straight monthly gain. This could indicate that the capital expenditure plunge triggered by the precipitous decline in oil prices may have leveled off.

Former Treasury Secretary Larry Summers said in a Washington Post opinion piece that it would be a serious error for the Fed to hike rates in September. Doing so would jeopardize price stability, financial stability, and even full employment, he wrote. His opinion is seemingly shared by New York Federal Reserve President William Dudley, a top Federal Reserve policymaker, who said that he’s less interested in a Fed “liftoff” next month, citing “international and financial market developments”. “From my perspective, at this moment, the decision to begin the normalization process at the September FOMC meeting seems less compelling to me that was a few weeks ago,” he said. However, other Fed officials are more hawkish. Kansas City Fed President Esther George said in a CNBC interview that recent market action “complicates the picture, but I think it’s too soon to say that fundamentally changes that picture. So in my own view the normalization process needs to begin and the economy is performing in a way that I think it’s prepared to take that.”

In the Eurozone, loans to business rose +0.9% for the year in July. Household borrowing was up a +1.9% yearly gain versus +1.7% in June. The data suggest that the European Central Bank’s efforts to boost the economy may be finally resulting in more demand. Consumer confidence also improved in the Eurozone as the EU commission sentiment tracker rose 2 ticks to 104.2. Consumer, retail, and construction sectors all rose. The German Economy Ministry soothed concerns that a slowdown in China will have significant negative impact in Germany, pointing out that German exports to China account for only 6.6% of total exports.

On Tuesday, China’s central bank cut interest rates and reserve requirements after several days of pronounced weakness in its stock market, which declined more than -7% on Tuesday and more than -8% on Monday. The People’s Bank of China cut interest rates by 25 basis points to 4.6%. It also reduced bank reserve requirements by a half percent, a step which should flood roughly $100 billion into the financial system. The government has stated its intentions of rebalancing the economy towards the service sector and consumption, and away from export-oriented manufacturing.

Finally, the volatility of this past week has many nervous investors searching for good news. Institutional research firm Ned Davis Research provided that dose of good news this week when it wrote about what it calls “the best indicator you’ve never heard of” – and it is bullish. This indicator is constructed from the stock market’s Price to Earnings (PE) ratio plus the unemployment rate plus the inflation rate. The latter two are sometimes combined into a number called the “Misery Index”. As the chart below shows, the stock market’s historical performance has been far better when this indicator is lower than when it is higher – and we are now in the second-lowest quartile, thanks mostly to a low unemployment rate and very low inflation, nicely offsetting a fairly high PE ratio. By this metric, anyway, the long-anticipated market correction that has finally occurred may be unlikely to become the beginning of a major bear market. See the chart below, from marketwatch.com.

(sources: Reuters, Barron’s, Wall St Journal, Bloomberg.com, ft.com, guggenheimpartners.com, ritholtz.com, markit.com, financialpost.com, Eurostat, Statistics Canada, Yahoo! Finance, stocksandnews.com, marketwatch.com, wantchinatimes.com, BBC, 361capital.com, pensionpartners.com, cnbc.com; Figs 3-5 source W E Sherman & Co, LLC)