MarketView for May 15

Summary

There is no question that it was a down day on Wall Street on Thursday, giving the Dow Jones Industrial Average and the S&P 500 their worst declines in more than a month, as small-cap shares extended their retreat and Wal-Mart results disappointed.

The Russell 2000 index of small-cap stocks lost 0.7 percent, well off its session low where it hit correction territory, down more than 10 percent from its early March record close of 1,208.65. It ended down 9.3 percent from that high.

Thursday marked the second day of losses the three major U.S. stock indexes, with volume picking up on S&P 500 e-mini futures, underscoring some views that the selling may continue. At 2.2 million, e-mini futures volume was well above the 1.5 million daily average volumes for the past year. The S&P 500 briefly traded below technical support, its 50-day moving average, but ended above that level.

Wal-Mart fell 2.4 percent to $76.83, weighing on both the Dow and the S&P 500. The world's largest retailer forecast second-quarter profit below analysts' estimates. Wal-Mart reported its smallest growth in quarterly sales in nearly five years and a drop in first-quarter profit, saying that severe winter weather made it difficult for customers to visit its stores.

With the Dow and the S&P 500 near record highs, the Russell 2000's move raised concern about the strength of the broader market. Meanwhile, the CBOE volatility index 8.2 percent. The spread between the spot VIX and the 3-month VIX at one point tightened to its smallest since April 15.

Adding to bearish views, billionaire hedge fund manager David Tepper sounded cautious late Wednesday, saying he was "nervous" about the stock market but that this was not the time to sell.

Economic data was mixed, though industrial output fell at its fastest rate in more than 1-1/2 years in April as factory production slumped, tempering hopes for a large increase in economic growth after a winter slowdown. Initial claims for jobless benefits hit a seven-year low last week, while consumer prices recorded their biggest increase in 10 months in April, pointing to a firming economy.

Among the day's gainers, Cisco rose 6 percent to $24.18, a day after the network equipment maker posted a shallower-than-expected drop in quarterly revenue.

Unemployment Claims Fall

The Labor Department reported before the markets opened that initial claims for state unemployment benefits fell by 24,000 claims to a seasonally adjusted 297,000 claims number, while consumer prices recorded their largest increase in 10 months in April, pointing to a firming economy. It was the lowest reading for unemployment claims since May 2007 and brought claims back to their pre-recession level.

Claims had been volatile in recent weeks because of difficulties adjusting the data during the Easter and Passover holidays and school spring breaks, which fall on different calendar days every year.

The four-week moving average for new claims, considered a better measure of underlying labor market conditions as it reduces week-to-week volatility, fell by 2,000 claims to 323,250 claims.

The labor market is strengthening after losing strength in December and January because of an icy-cold winter. Nonfarm payrolls increased 288,000 in April. Meanwhile the number of people still receiving benefits after an initial week fell by 9,000 claims to 2.67 million claims for the week ended May 3, the lowest since December 2007.

In a second report the Labor Department reported that its Consumer Price Index increased 0.3 percent last month as food prices rose for a fourth consecutive month and the cost of gasoline was sharply higher. The CPI increase was the largest since June last year and added to March's 0.2 percent rise.

In the 12 months through April, consumer prices rose 2.0 percent after gaining 1.5 percent in March. The increase was the largest since July last year and in part reflected prices coming off last year's low base when energy costs decreased.

Stripping out food and energy prices, the so-called core CPI rose 0.2 percent after advancing by the same margin in March. In the 12 months through April, the core CPI increased 1.8 percent. That was the largest gain since August last year and followed a 1.7 percent rise in March.

The combination of a strengthening jobs market and an uptick in inflation pressures should give the Federal Reserve ammunition to continue scaling back its monetary stimulus. However, the Fed is not expected to start increasing overnight interest rates, currently near zero, before the second half of 2015.

The Fed targets 2 percent inflation and it tracks an index that is running even lower than the CPI. The Fed has been concerned that inflation is running too low, but the steady increase in prices should ease those concerns.

Separately, the New York Federal Reserve said its "Empire State" general business conditions index came in at 19.01 this month, the strongest reading since June 2010. It was at 1.29 in April. Readings above zero indicate growth. New orders surged after contracting in April and inventories also increased, as did shipments.

The Fed Tries to Gauge Unemployment

The Federal Reserve continues to try to size up the strength of the labor market. To Mary Daly, a top economist at the Fed's regional branch in San Francisco, a full assessment should go beyond the jobless rate to take into account stagnant wages, the large numbers of long-term unemployed and a drop in labor force participation.

"We don't really have a really, tight labor market," she said.

As a result the Fed is likely to hold off tightening monetary policy until a clearer picture emerges because by most accounts, the jobless rate is higher than Fed officials would like it to be. However, differences are becoming more pronounced over how much more room the economy has to run before labor-market tightness risks sparking inflationary wage pressures.

Interpreting the tightness of the labor market has been complicated because the decline in the jobless rate, which hit a post-recession peak of 10 percent in October 2009, has been accompanied by a big decline in the proportion of working age Americans participating in the labor market.

Daly estimates a quarter to a third of Americans who left the workforce in recent years will return once the job market gets hot. In her view, their return will keep a lid on earnings, which have been largely stagnant. Only when the unemployment rate nears 5 percent, she said, would she "expect to see the beginnings of some upward pressure on wages." And even then, she said, the rise will be gradual, giving the Fed ample time to respond.

Nonetheless, the Fed has the concern that simply watching wages could lull the Fed into a false sense of safety, leaving it facing inflation with little warning. So, too, could reading too much into alternative measures of labor market slack.

Another reason economists can't agree on the health of the labor market is the difficulty in estimating how low unemployment can go before wage pressures start to build. Fed officials estimate that figure falls somewhere between 5.2 percent and 5.6 percent, but it can fluctuate.

In March, Daly's boss, San Francisco Fed President John Williams, published research that suggested the "normal" rate of unemployment may have risen to around 6.5 percent. Not only is that higher than the current rate of unemployment, it is also a full percentage point above what Williams has repeatedly said is his own view of "normal."

Daly, asked about Williams's research, said that stagnant wages suggest there is still plenty of labor market slack, and stuck to her estimate for sustainable unemployment of 5 percent.

Factory Output Lower

According to a report released by the Fed on Thursday, factory output fell in April after two months of strong growth. Manufacturers produced less furniture, machinery and plastics. According to the Fed’s report, factory production in April dropped 0.4 percent from the previous month after rising a revised 0.7 percent in March and 1.5 percent in February. Manufacturing output has risen a solid 2.9 percent over the past year.

Overall industrial output, which includes manufacturing, mining and utilities, fell 0.6 percent in April. Output at utilities plunged 5.3 percent; households used less heat as temperatures rose.

Other measures of manufacturing have looked healthy. The Institute for Supply Management has reported that U.S. manufacturing grew faster in April than March. The Commerce Department has said orders to U.S. factories for long-lasting manufactured goods showed decent gains in February and March.