What a difference it makes to turn the page on one quarter and begin another. Up until September 30, the market had endured a difficult summer. The year to date loss on the S&P 500 was 8.7%. While it is only a coincidence of the quarterly calendar, from October 1st through the 17th the S&P 500 gained 6.1%. Why has this happened?

 

While much of the economic news before the end of the quarter pointed to stable-to-slightly-negative growth, since then the numbers look stable to positive. Responding to this pre-quarter end weakness, on September 21st the Federal Reserve announced a program called "Operation Twist." The Fed concluded there are "significant downside risks to the economic outlook, including strains in the global financial markets." "Operation Twist" will recast the Fed's $2.65 trillion securities portfolio by reducing holdings in short-term securities and replacing them with long-dated U.S. Treasury bonds and mortgage debt. The Fed's move is an effort to reduce long-term interest rates, particularly for housing, as money freed up from refinancing mortgages can be used to spur consumption. Initially the program worked, as 10-year Treasury bond yields dropped 0.16% to 1.72% the day after the announcement. However, the market had believed that such a program would be announced for several weeks and had been driving down long-term rates in anticipation; for proof the 10-year Treasury yielded 3.0% as recently as July 25th.

 

However, the combination of better economic news and a possible deal to restructure Greece's government debt led investors to conclude that things are not as bad as expected. Besides the stock market advance, better economic news pushed the 10-year Treasury yield back up to 2.15% on October 17th. Other news-sensitive instruments have reacted similarly. Crude oil jumped from $79.20 per barrel to $86.38, while gold increased from $1,620 per ounce to $1,682.

 

How did this happen? It started on September 29th when the government announced that GDP growth for the second quarter had been revised up from 1.0% to 1.3%. Gross domestic income advanced 1.3%, consumer spending grew 0.7% and inflation as measured by the personal consumption expenditure price index increased 3.3%, down from 3.9% in the first quarter. While not great, the revisions put the economy on slightly better footing than previously thought.

 

The next piece of better news was the release of the Purchasing Managers Index, which showed manufacturing expanded in September with a reading of 51.6, up from 50.6. Any reading above 50 indicates growth. However, new orders contracted slightly, declining 0.2%. Car sales appear to be at the heart of the advance, as automakers recovered production lost from supply chain disruptions caused by the Japanese Tsunami in the spring. Sales of cars and trucks in September advanced 10%, to an annualized selling rate of 13.1 million, and nondefense capital-goods orders excluding aircraft rose by 0.9%.

 

Employment for September came in better than expected, although the pace of new hiring is still below what is needed to make a dent in the unemployment rate, which was unchanged at 9.1%. 103,000 jobs were added for the month, but more importantly, August job growth was revised to 57,000 versus zero as originally reported. Private sector employment growth was 137,000, aided by adding 45,000 Verizon Communications workers who were on strike in August and counted as unemployed. Continuing recent trends, government cut 34,000 jobs, mostly at the state and local levels. The average work week grew 0.1 hours and hourly earnings advanced 0.2%. These figures illustrate modest growth, which is inconsistent with recession.

 

Retail sales advanced nicely in September as well, increasing 1.1%. Cars and trucks led the way, increasing 3.6%. However, excluding the auto sector, sales still advanced 0.6%, so consumers are buying other items as well. August retail sales were revised up to growth of 0.3% versus the original estimate of zero.

 

Against this generally favorable backdrop of data was the release of August personal income, which showed a decline of 0.1%. The deceleration in personal income growth over the previous few months has been consistent: April grew 0.4%, May grew 0.3%, June grew 0.2%, and July grew 0.1%. The pattern is a concern because consumption accounts for roughly 70% of GDP, and if consumers don't have income growth they can't continue to increase spending. We would expect personal income to resume growth given better manufacturing and employment numbers.

 

We believe that the economy will continue making modest progress as Americans continue to reduce debt and the housing market comes into better balance. The stock market's decline in August and September seemed to be pointing at something worse, but the market is notorious for predicting recessions that never materialize. We continue to advocate purchasing well-run, consistently growing companies. The recent weakness in stock prices looks like a good buying opportunity.