It Will Get Better

The recent ebullience was indeed suspect and mid-May brought a change in weather. The sunshine of two weeks ago turned to rain. The market is down and shrill calls of further losses ahead are ringing in the ears of investors.

For the week:

Dow -2.1%
Nasdaq -2.2%
S&P; 500 -1.9%
S&P; Midcap 400 -3.4%
S&P; Smallcap 600 -2.3%

Last week, investors focused on the Fed’s policy statement, which did not indicate a pause for interest rate increases. The Fed said that it would be looking at incoming data to determine its future rate activity. It’s most concerned about inflation. Investors joined the Fed in watching incoming data for clues to the future.

This week we got the first installment, and it wasn’t good. On Wednesday, the core consumer price index (CPI) increase for April came in at +0.3%, a tiny 0.1% higher than expected. Because the core CPI measures consumer inflation for all goods except food and energy, the red flags flew high again.

By itself, maybe the April CPI wouldn’t have been a big deal. However, it was the second month in a row that we’ve seen it increase by 0.3%. The Fed’s forecast for this year is an increase of just 1.75% to 2%. That’s a monthly equivalent of just 0.15%, or half of what we’ve gotten in the past two months. Remember:

Signs of inflation = More interest rate increases

Interest rate increases are not good for the stock market, so it fell. Rate increases put a damper on earnings. Currently, investors expect the second half of the year to see an earnings increase of about 10%. If rates go much higher, though, that might not be possible. Thus, stock prices go lower to account for the potential of lower earnings in the second half.

As ominous as the above reads, the situation is not much different than what we saw a couple of weeks back. What has changed is perception.

Before, the end of rate increases was seen as being just around the corner, so earnings were going to be fine and the market rose on those high hopes.

The only thing that flipped the coin was that the Fed said it wasn’t sure when rates would stop rising because it hadn’t seen all the data yet. That means we could get another increase in June to 5.25%.

Or not.

Don’t dismiss that last possibility. The Fed’s next meeting is a month away. If the world can change this much in two weeks, don’t you think it can pull off another transformation in a whole month? You bet it can. It does it all the time.

All we’re really quibbling over is whether there will be a June increase. There’s always been a possibility of getting one. All the way back on April 10, I wrote:

The committee said it will continue watching economic data for direction. That means we could keep going beyond 5%. Will we get a 5.25% rate at the June 29 meeting? The futures market puts the odds at around 45%.

Even if we do get one but it comes with mollifying comments from the Fed, I think the market will see that as good news. If we don’t get one and the statement is calming, I think we’ll get a solid upswing in stocks. The only situation that would be harsh is another increase along with stern language indicating that there’s no end in sight to the increases. Combined with what I see as a rough time in August/September, that could make for an unpleasant summer.

Truly awful? Not really. From the beginning of the year, I’ve been writing about the summer slump. We’re in the weak half of the year already, and stocks are down. Not too shocking. We look ready for an oversold bounce during the remainder of May. If that gets followed by some positive inflation news, and that gets followed by a positive Fed meeting in June, we will see those higher prices I expect before the real sell-off begins.

That’s the scenario I’ve been aiming at all year, and I still have my sights on it.

I found another fellow in my camp, somebody you may have heard of: Tom McClellan, of the McClellan Oscillator fame. The McClellan Oscillator is a measure of momentum applied to advance/decline readings. It generates buy and sell signals along with overbought and oversold readings. The technique was developed by Sherman and Marian McClellan. Tom is their son and works with his father in publishing The McClellan Market Report.

At the end of April, Tom forecast mid-May weakness. That was just as the market was scaling to old highs. It was a bold call, and accurate. He says now that the selling should end by May 23 and that the market should rise to new highs by the end of June. He then sees a choppy, sideways market into a weak spot in the fall, but not a dramatic crash. Beyond these mid-term predictions, Tom is calling for oil and energy stocks to bottom out in June, and then advance until year-end. He expects $100 oil and $4-a-gallon gasoline as well.

While I think we’ll have more trouble at the end of summer than Tom thinks, he and I are in complete agreement for the next month or so.

Lest you feel panicked, recall that the price/earnings ratio for the S&P; 500 is less than 16 on operating earnings and less than 18 on reported earnings. No signs of overheating there.

For now, though, the market psychology is dominated by inflation reports and Fed prognostication. Keep an eye on the data. So far, despite the action of the past two weeks, it ain’t that bad.

On Tuesday, the Labor Dept. reported that the core producer price index (PPI) rose just 0.1% for a second straight month to leave the year-over-year increase at 1.5%. That’s under control.

On the same day, we received reports that the housing sector is slowing down. April housing starts came in at their lowest level since Nov. 2004. Building permits also went down for the third month in a row. These data bolstered the view that the Fed should pause in June. Indeed, Fed funds futures still show just one more rate increase.

Sift through it all, and the only downer you’re left with is that the core CPI was just 0.1% higher than expected. A reason to squint the eyes? Sure. A reason to buy emergency rations? No. Aside from sentiment taking a decided turn for the sour side of life, the fundamentals are not much different than they were when the Dow was approaching all-time highs at the beginning of the month.

Moreover, I’ve been pretty impressed with the Fed so far, and I’m not the only one. On Friday, Treasury Secretary John Snow spoke to the Bond Market Association. He said he’s confident that the Fed will control inflation, and he seemed unconcerned about inflation: “”Overall growth is strong, and while it’s true that headline inflation has picked up, core inflation remains in check,” he said. He pointed out that the economy’s expansion is still healthy thanks to low taxes and hefty business investment. Unlike the expansion of the late 1990s, this one does not smack of “irrational exuberance” and is durable.

Also on Friday, Kansas City Federal Reserve President Tom Hoenig spoke with Greg Ip of The Wall Street Journal. He said he thinks inflation and growth will slow, despite the recent data. He also said that the Fed is aware that the effect of rate hikes is delayed, so we’re not yet seeing the benefits of past increases. “Let’s maybe be a little bit patient here, and then decide what the right course is,” he said. That’s roughly the Fed’s official stance: wait for the data.

This is an opportune time to point out something basic about the market. The only reason we can make money in it is that its prices change. They go up, they come down, and they do it again and again. While nobody can get the exact points right, we can get the trends basically right, and that’s often good enough. The market is down now, but it won’t stay down forever. When it rises again, it won’t stay up forever. These movements are natural and should not be disconcerting.

What we should do is build a solid portfolio for the next up-sw
ing. In that spirit, we’re still trying to buy Investments are shown only to KELLY LETTER subscribers. Click to try the letter for one cent. at $29. More on that below.

I have fresh reports on Applied Materials, Dell, Intel, RadioShack, Profunds Ultra Japan, and Yahoo. Every one of them is yours with a one-cent, one-month trial subscription to The Kelly Letter, which includes complete access to my archived research in the subscriber section of this site. It’s hard to imagine a better place to get a full month of research time for a penny.

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