The S&P and the NASDAQ were flat last week. The Dow was down about 200 points, the result of its 300 + point sell-off on Thursday. Citigroup was the culprit. Its bigger than expected write-downs cost the Dow and cost its CEO his job. With the CEO of Merrill losing his job at the beginning of the week, it turned out to be a very bad week for financial company CEOs. (Is the CEO of Bear Stearns next?) All the financial stocks suffered as a result of Citi’s and Merrill’s woes but the cause of their woes is old news. We already knew about the subprime and collateralized debt problems and we knew the third quarter was going to be bad for banks and their brethren.
The Fed cut rates by ¼ point. Cuts in Fed Funds rates usually boost financial stocks. Not last week. The jobs report on Friday was tremendous. 166,000 new jobs were created, twice the estimate, and well above the 100,000 mark, a broad-brush delineator between strong and weak job growth.
What didn’t the stock market like last week? Oil approaching $100 a barrel? Maybe we’re finally reaching the tipping point where energy prices put a brake on the economy. But, it doesn’t feel like it. That leaves us with the housing market as the guilty party. But wait, the new home building market bottomed a few months ago and isn’t getting any worse (it’s not getting any better, either, and probably won’t for at least another year). What’s left is the value of existing homes (and slow sales/declining prices in the existing homes market). If the value of existing homes continues to decline, the consumer will feel the reduction in his/her net worth and will cut back on spending. (And, no more home equity loans and refinancing to take money out). If homes values continue to decline, a recession will certainly follow. Throw on top of this rising energy prices and we have the makings of a category three economic storm. This is the wall of worry which the stock market must climb. (If the market had no worries, the averages would be significantly higher and the potential reward wouldn’t be there.)
Assume for the moment that housing values, and energy prices, level off – don’t improve but don’t get worse. Then, we’re left with a low-inflation, export and technology-led economy with new jobs being created each month. If this is the case, then as I’ve said for the past few weeks, the stock market is reasonably valued, 2008 corporate earnings estimates are in tact, and the stock market could rise by 20% over the next six - nine months.
Oh, by the way, the decline on the Dow as compared to the S&P shows the value of diversification. I’m not suggesting you buy 500 stocks, 30 stocks really are enough but the comparison of the performance of the two indices last weeks illustrates why you diversify.
