The modest reset lower that we have seen materialize over the past two weeks may have more room to run — on the down side. Since August 7, the Dow Industrials (^DJI, DIA) have given back 383 points or 1.73%. The S&P 500 (^GSPC, SPY) has slipped 0.08%, and the technology-weighted Nasdaq (^IXIC, QQQ) has led the way lower with a 2.61% move. The recent price action in equities has left our uptrend under pressure as distribution days have mounted. As evidenced by the Nasdaq’s outperformance to the down side in the period referenced, it has accumulated the greatest number of distribution days over the past month (nine total). The S&P 500, on the other hand, has totaled five distribution days over the same period. In fact, on Friday the Nasdaq negative performance was the result of a significant intra-day reversal and matched with accelerating volume — an indication that institutional sponsorship is behind the selling.
As we have discussed since mid-summer, the market is a bit wear worn and need of a reset both in order to consolidate gains and compress valuations but also to provide a more sustainable platform with which to move higher — predicated upon anticipated earnings growth and accelerating economic data.
In both cases, earnings and economic data, there remain reasons to be constructive on the market once our called for modest reset finds a tradable bottom. Second-quarter results from S&P 500 reporting companies have been solid with 65% beating consensus expectations. Guidance has largely also been quite positive. Most recent economic data has also suggested the US economy is on better footing that it was in the first half of the year. From employment report data to weekly jobless claims and initial Q2 GDP data (all of which we have covered), it is clear that the economy is reaccelerating after a unexpectedly weak first half.
For example, last week’s top line retail sales data for July came in at +0.6% versus expectations of +0.3%, Further, June’s retail sales figures were revised to +0.3% from -0.2%. The Empire State Manufacturing Survey for August was a stunning 25.2 versus consensus of 9.8. The Housing Market Index for August was 68 versus consensus of 65. In a nod to the emergence of healthy inflation, the Atlanta Fed Business Inflation Expectations reading for August was 1.9% on a year-over-year basis. The prior reading was 1.7%. Leading Indicators for July came in at 0.3%, matching consensus.
The largest variable for investors is the anticipated Federal Reserve balance sheet reduction effort, given the constructive economic data and earnings backdrop outlined in recent notes and above. In the FOMC minutes released last week, there was clearly a divided committee. Some members were pushing for a step into balance sheet reduction in July while others felt it more prudent to wait until the September meeting. Those members who wanted to wait until September won the argument. The argument being that a modest uptick in inflation before the September meeting is likely, and in that case, it would make the runoff a bit less disruptive to credit markets.
Given the data outlined above, I think investors are likely expecting some follow through on balance sheet reduction in September. In any case, the balance sheet reduction that does likely commence in September will be very modest and, at least initially, very limited as to not disrupt markets. The cautious approach to reduction will to a large degree be informed by the backdrop of gradual monetary tightening.
This week’s economic calendar is light. Jackson Hole will dominate and investors will be playing close attention to Yellen’s talk on Friday at 1:00 p.m. Eastern. Additionally, this week will provide some insight into the strength of the manufacturing sector in the form of releases from the Richmond Fed and Kansas City Fed. Otherwise, the Chicago Fed National Activity Index, out Monday, will be viewed as an indicator of what to expect this week.