Corporate earnings take center stage in the equity arena

Exciting week for equities
Volatility seemed sharper than normal these past couple of weeks. A week ago, the Dow posted its largest one-week decline in a decade. This week, most of the drop was reversed. However, prices fluctuated widely every single day. There was not only a lot of variability from day to day, but also within the day. For instance, earlier this week, the Dow jumped nearly 200 points because Microsoft announced favorable earnings. The next day, the Dow fell nearly 100 points because IBM not only had a poor earnings report, but also mentioned that sales would be affected through the end of the year because of Y2K. (Maybe they hadn't heard of Y2K before?) Anyway, the drop in Thursday's DJIA was entirely due to IBM, otherwise, the index would have risen modestly.

So why are stock investors so edgy? They are worried about the uncertainty of Y2K issues, but even more concerned about the prospect of a series of Fed rate hikes. Is inflation really a problem these days? And Fed chairman Alan Greenspan talks like he has an itchy trigger finger. Thus far, the Dow has managed to close above the psychologically important 10,000 level. Looking at the year as a whole, the Dow is still showing a respectable gain. Unfortunately, many investors got in this summer as stock prices were peaking. Many stocks are down at least 10 percent from their highs, as is the Dow, which counts as a "market correction."

The chart shows the continued exuberance in the NASDAQ composite. Even though this index is down from its highs, it is still 28 percent higher than yearend! One has to admit this is a phenomenal run. The S&P 500 is only 5.9 percent above yearend levels. Compared with the Dow and the NASDAQ, it appears meager. Yet, given the long-term perspective of several years of double-digit gains, this remains impressive. (Only if you didn't buy at the market peak this summer.)

The Russell 2000 takes it on the chin every time there is a market correction. Once again, the Russell universe of small capitalization stocks is running below yearend levels. It has a long way to go to return to levels last seen in 1998.

US bonds worry about Fed tightening and potential rate hike in Europe
This week's economic news was not sufficient to put bond investors at ease over inflation issues and the potential for Fed tightening. Moreover, expanding growth in Europe is cause for concern since the European Central Bank is now aiming to raise their target rate to 3 percent from 2.5 percent. This is cause for trepidation among US investors because it points to a global recovery and greater competition for funds. This past week, increases were more dramatic in the 2-year to 10-year range on the yield curve. Moreover, if you were interested in buying off the run (securities with odd-year maturities such as 24 or 27 years, for instance) Treasuries, you could easily have seen yields in the 6.5 percent to 6.7 percent range.

CPI comes in on expectations; a relief after hefty PPI
The consumer price index increased 0.4 percent in September - in line with expectations - but less fearful than the PPI figures reported the previous week. This was the largest monthly gain since April when special factors last boosted the index. In September, energy prices did account for part of the gain. In addition, apparel prices increased 1.2 percent and tobacco prices surged 6 ½ percent. Apparel prices are still 1.3 percent below year ago levels. Each new season (spring, summer, fall or winter), apparel prices tend to burst, but always reverse in subsequent months. Indeed, a downward trend in apparel prices is evident. This reflects a problem with seasonal adjustment. The tobacco price hike should not be repeated any time soon. Despite these special factors, note that the core CPI (less food and energy) is trending lower.

The chart below depicts the prices of goods and services. While goods prices have picked up steadily (and this does reflect energy and tobacco), the prices of services are rather stable and edging slightly lower over time. Since the service component of the CPI has a greater weight (about 57 percent), the uptick in goods should be less worrisome.

The bottom-line on inflation? While many investors worried about the possibility of deflation (falling prices) just two years ago, we are once again facing the potential for accelerating price hikes. We don't have the "luxury" of recessions in countries around the globe hoping to sell us their unwanted goods at rock-bottom prices. On the other hand, U.S. corporations have put in place compensation and pricing policies in the 1990s which are probably more anti-inflationary than any other time in the past thirty years. The Fed continues to worry about accelerating wages in tight labor markets, and their impact on the economy as they seep through to the consumer. But runaway inflation is not a "done deal" these days. In any case, the Fed and market professionals will focus all their attention on the employment cost index this coming week. While this data might force the Fed's hand into raising rates at the November 16 FOMC meeting, it doesn't necessarily set the stage for an accelerated pace of Fed tightening moves.

Housing starts moderate
Housing starts decreased 3.2 percent in September after slipping 0.5 percent in August. Starts are now only 2.7 percent above year ago levels. Hurricane Floyd probably affected the September data. Starts weren't particularly soggy in the South, but plunged 25.7 percent in the Northeast. Rainstorms, which shut down much of New York City for a day the week of the hurricane, hit this region.

The bottom-line on housing? Even economists who specifically follow the housing market have been astounded at its strength in the past couple of years. It is likely that rising mortgage rates will hamper this industry in coming months. Moreover, if income growth stabilizes at slightly lower levels and the stock market doesn't skyrocket in coming months, consumers may think twice about buying bigger and better homes.

International trade deficit stabilizes at record highs
The international trade deficit on goods and services narrowed modestly in August to $25.1 billion from a $25.9 billion shortfall in July. A surge in aircraft shipments helped to sharply boost exports. Yet, new orders for aircraft have declined this past year, so this particular export may wind down in coming months. Nevertheless, the recoveries in Europe and Asia do point to improved export activity for U.S. manufacturers in coming months. Imports jumped sharply in August to reach a new record. The demand for imports reflects the continued strength in the U.S. economy. The healthy demand for imported goods helps keep alive competitive pressures and also helps alleviate supply shortages.

The bottom-line on international trade? The large trade deficit in the past couple of months will help to drag down real GDP growth in the third quarter, although perhaps at a slower rate than earlier this year. The boost in exports is likely to continue in coming months and may allow the trade deficit to narrow as foreigners demand more U.S. goods and services.

THE BOTTOM LINE
The consumer price index was reported in line with expectations. In a normal period, market players would have sold off on the news. Instead, the stock market rallied because the CPI gain was more moderate than the burst in producer prices. This past week's news was light on the economic front and stock market players focused on corporate earnings. The bond market was monitoring activity in Europe. Would the European Central Bank raise rates or not? They didn't, but the negative sentiment from rumors of a potential rate hike in Europe led bond yields higher in the United States.

The coming week is filled with key economic news such as third quarter GDP and the employment cost index. Both are key elements in the tool kit of Federal Reserve officials. It really is too soon to determine whether the Fed will raise rates at the next FOMC meeting. Polls generally show that half the Wall Street economists are expecting a hike, while the other half are not. Sentiment could change more dramatically in the next couple of weeks - employment for October will be out before the next FOMC meeting.

Looking Ahead: Week of October 25 to 29
We use the Market News Service survey of forecasts to describe the market consensus.

Monday
Existing home sales are expected to decline 1.9 percent in September to a 5.15 million unit rate. If this forecast were realized, it would be the fifth decline in six months. Higher mortgage rates and greater volatility in the stock market could help curtail housing activity.

Market players expect the Treasury to post a budget surplus of $55 billion in September, the last month of the fiscal year. This would be larger than the surpluses posted in 1997 and 1998 for this month. It also would bring the annual budget surplus up to $125 billion, nearly twice the size of last year's $70 billion surplus.

Tuesday
Market participants are looking for The Conference Board's consumer confidence index to edge down to 133 in October from 134.2 in September. Labor market conditions remain good, and outside of energy, prices are still stable. Consumers might be less sanguine about the stock market drop in September and October.

Wednesday
The consensus forecast is showing a 0.7 percent drop in durable goods orders for September. New orders for durable goods have posted steady gains since April, making this potential decline less worrisome for the manufacturing sector. Also, market players might be surprised by a boost in aircraft orders.

Thursday
Market participants are expecting new jobless claims to decrease 5,000 in the week ended October 23 from last week's 298,000. Claims remain range-bound.

Economists are predicting that real GDP grew at a 4.7 percent rate in the third quarter, after gaining at a modest 1.6 percent rate in the second quarter. This partly reflects some inventory building and a smaller drag from net exports. But gains are generally expected across the board. The GDP price deflator should rise at a 1.3 percent rate, matching last quarter. This does include higher energy prices, though. The GDP forecast should be viewed with more caution than usual - it incorporates annual benchmark revisions which were normally undertaken July.

Market players expect the employment cost index to increased 0.9 percent in the third quarter, less than the 1.1 percent gain posted in the second quarter. This would keep the year over year gain at 3.2 percent. This quarterly compensation index may get more attention than the GDP figures on Thursday since market players know who important this information is to Fed officials.

Friday
The Chicago purchase managers index is expected to increase to 57 in October, from a level of 53.8 in September, pointing to stronger manufacturing activity. At the same time, market players will focus on the prices paid component of this series. In September the prices paid index stood at 71.

Economists are predicting that new home sales will decrease 4.4 percent in September to a 940,000 unit rate, just about reversing the gains of the previous two months. The strength in home sales has astounded even housing market specialists. The general view is that housing activity will moderate with the higher level of interest rates.