David Kelly on the week ahead: Fundamentals and a wall of worry

The last seven weeks have seen a significant correction in the stock market, along with a surge in stock market volatility.

The last seven weeks have seen a significant correction in the stock market, along with a surge in stock market volatility. The market’s problems appear to be partly a reflection of genuine fears about the European debt crisis and partly the impact of $30 billion in net outflows from equity mutual funds in May.

On the first issue, a combination of actions taken collectively by European governments and the European Central Bank to backstop sovereign debt and strong measures taken by individual governments to cut their budget deficits should remove the risk of another full-blown financial crisis. On the second, a steady drip of positive economic numbers should, over time, coax investors back into the equity market. If this is the case, prospects for the stock market should once again depend on the two key fundamentals of stock market valuation, namely, profits and interest rates. These, in turn, depend critically on economic growth and inflation, and numbers due out this week should provide further guidance in these areas.

On the growth side, May Housing Starts data due out on Wednesday, should show some decline in overall starts but a pickup in building permits following a surprising tumble in April. Industrial Production should rise strongly, logging its tenth increase in the last 11 months, reflecting increases in the manufacturing workweek and warmer-than-normal May weather which should have boosted electricity output. Jobless Claims on Thursday should show a further decline as the labor market continues its painfully slow convalescence. Perhaps most reassuring will be the Index of Leading Economic Indicators, due out on Thursday, which should show a strong gain for May following a fluky relapse in April. Overall, despite fears of a slowdown and some disappointing numbers in the last two weeks, the U.S. economy appears to be growing at close to a 4% annualized rate as the second quarter draws to a close.

On the inflation side, numbers should be very low with a whiff of deflation. Tuesday’s numbers on Import Prices and Export Prices may show both fell in April. Meanwhile, lower energy prices may have contributed to a decline in headline PPI and CPI, due out on Wednesday and Thursday respectively, although core measures of inflation may post slight gains in both cases.

Moderate economic growth, if sustained should continue to foster a strong pickup in corporate profits. The third-quarter earnings season commences in a few weeks, and analysts are looking for an S&P500 operating number of $19.61, following an estimated $19.37 for the second quarter. It is worth noting that, three months ago, the same analysts were expecting a number of $17.17 for the second quarter, an estimate which companies on aggregate had no problem beating. This being the case, it would not be a surprise if $19.61 turns out to be a low-ball estimate. Even if it is not, as of this morning, the S&P500 is trading at 1091.60, just 12.4 times the operating earnings expected over the next 12 months, and the stock market would need to rise by more than 30% to reach the P/E ratio of 16.6 times future expected earnings which it has averaged since 1993.

On the interest rate side, next week the Federal Reserve’s Open Market Committee will conduct a two-day meeting to consider monetary policy. Recent statements from Fed officials make it clear that they have no intention of beginning to tighten any time soon, as they see inflation risks as low and worry about the possibility of a relapse. However, while everyone continues to worry, the recent trend of low rates and rebounding profits should be sustained, suggesting that long-term investors should still consider an over-weight to U.S. stocks.

Tuesday, June 15th

Import and Export Prices Forecast Last
Import Prices, %ch – 1.2% 0.9%
Export Prices, %ch – 0.3% 1.2%

Wednesday, June 16th

Producer Price Index Forecast Last
Overall, %ch – 0.3% – 0.1%
Ex-Food and Energy, %ch 0.2% 0.2%

Housing Starts Forecast Last
Starts, mils, ann rate 0.606 0.672
Permits, mils, ann rate 0.666 0.606

Industrial Production Forecast Last
Production, %ch 1.2% 0.8%
Capacity Utilization, % 74.6% 73.7%

Thursday, June 17th

Jobless Claims Forecast Last
Initial Claims, 000’s 445 456
Continued Claims, 000’s 4,485 4,462

Consumer Price Index Forecast Last
Overall, %ch – 0.1% – 0.1%
Ex-Food and Energy, %ch 0.1% 0.1%

Leading Economic Indicators Forecast Last
Index, %ch 0.9% – 0.1%

David Kelly is the Chief Market Strategist for JPMorgan Funds