MarketView for October 26

Summary 

Dramatic events have a tendency to bring trading activity to a near halt on Wall Street as the associated possible outcomes weigh on the psyche of investors. This week it is a combination of both the upcoming election and the rising anticipation ahead of what will likely be a major announcement by the Federal Reserve the day following the election. As a result, share prices were little changed on Tuesday.

Next week's high-profile events could signal shifts in both monetary policy and legislative direction, raising fears that trumped Tuesday's earnings news and economic reports. Weak quarterly reports from Bristol-Myers Squibb Texas Instruments with regard to their revenue performance sent both sets of shares lower for the day. Bristol-Myers closed down 1.1 percent at $26.86, while Texas Instruments ended the day down 0.3 percent at 28.88.

However, the day’s losses were ameliorated somewhat by gains in the consumer discretionary sector after the Conference Board's measure of U.S. consumer confidence rose more than expected. The S&P Consumer Discretionary index was up 0.4 percent, led by a 11.9 percent jump in Coach to $49.78 after the upscale leather goods maker posted higher-than-expected results.

Volatility also increased for the second straight session with the CBOE Volatility index .VIX up 1.9 percent as traders look ahead toward next week's events. Tuesday's trading activity also brought about a slight breakdown in the recent inverse correlation between stocks and the dollar, with stocks edging higher as the dollar advanced 0.8 percent against a basket of currencies.

U.S. Steel and ArcelorMittal sold off after reporting results. Both U.S. Steel and ArcelorMittal forecast a soft patch extending to the end of the year. As a result, U.S. Steel ended the day down 3.4 percent to close at $40.85, while AK Steel fell 4 percent to close at $12.84.

DuPont's earnings exceeded expectations, while at the same time the company raised its full-year earnings guidance. Nonetheless, the shares still managed to end the day down 1 percent to close at $47.22 after hitting a two-year high on Monday.

Tuesday's gainers included Ford Motor, which rose 1.5 percent to $14.36 and touched a six-month high after the quarterly earnings number exceeded estimates and it paid down a substantial portion of its debt.

IBM, a component of the Dow Jones industrial average, closed up 0.6 percent at $140.67 after the company announced on Tuesday that it was increasing its stock buyback program.

Economic Data Remains Weak

Tuesday’s economic data was essentially more of the same, weak. Consumer confidence numbers were anything but strong and home prices were down again after showing a bit of upside momentum earlier in the year. What the data did indicate was that the case for intervention by the Federal Reserve grows in strength on an almost daily basis. The Fed will likely make known its decision on Wednesday, November 3.

According to the data released by the Conference Board, an industry group, on Tuesday, consumer confidence rose slightly in October but remained near historically low levels as concerns regarding the labor market persisted.

The Conference Board, an industry group, said its index of consumer attitudes rose to 50.2 in October from a revised 48.6 in September. Furthermore, the rate of unemployment remains stubbornly high at 9.6 percent, according to the Labor Department.

The Federal Reserve, which has already injected $1.7 trillion into the economy by purchasing mortgage-related and government bonds, next meets on November 2-3. Another round of quantitative easing, dubbed 'QE2', is expected to focus on Treasury debt.

The weak labor market is one of the primary reasons why the housing market remains weak.

Prices of single-family homes fell for a second straight month in August, hovering around recent lows after the expiration of popular homebuyer tax credits, according a Standard & Poor's/Case-Shiller home price report on Tuesday.

The housing market has been struggling since home buyer tax credits expired earlier this year. To take advantage of the tax credits, buyers had to sign purchase contracts by April 30. Contracts originally had to close by June 30, but that was extended by three months.

Another report on Tuesday showed home price gains in August. The Federal Housing Finance Agency home price index is calculated using purchase prices of houses financed by Fannie Mae and Freddie Mac. The housing market, however, remains highly vulnerable to setbacks and most economists believe a recovery will be elusive until the labor market improves.

The Question of Excess Reserves

Stimulus program aside, Wall Street is trying to ascertain whether the Fed will or will not reduce or eliminate the interest it pays on the deposits held in reserve, which are the excess reserves of the banking system.

The Fed began paying interest on excess reserves two years ago to try to control more tightly the real interest rate compared with its fed funds target rate. Banks with cash reserves at the Fed currently earn 25 basis points on those deposits.

With short-term interest-rates at historic lows, the Fed's 25 basis-point interest rate looks like a comfortably safe and reasonable return as banks are not currently motivated to do much with their cash beyond hoarding it at the central bank.

Some economists argue that if the Fed were to reduce or eliminate interest payments on reserves, banks would put their money to work in other ways, such as new loans or real assets. They say such moves would be a more effective way to stimulate economic growth -- the ultimate goal of quantitative easing -- than Treasury purchases.

Indeed, interest in the move seems to be stronger in New York than in Washington. During a recent spate of public appearances here, Fed officials fielded audience queries about the potential move, even though the last official mention of it came in a speech Fed Chairman Ben Bernanke gave at the Fed gathering in Jackson Hole, Wyoming, in August.

Economists and strategists on Wall Street are almost certain that the Fed will announce another program to purchase Treasuries after its next Federal Open Market Committee Meeting ends on November 3. But questions remain as to whether more Treasury purchases will have the desired effect, since Treasury yields are so low already.

In response to questions on the topic during their appearances last week, Dallas Fed President Richard Fisher and Fed Governor Elizabeth Duke each acknowledged that cutting the interest rate on reserves was a tool the Fed could potentially use. But they did not give any indication that it was being seriously discussed as a policy move.

Philadelphia Fed President Charles Plosser said on Friday that the move could disrupt short-term funding markets.

Money-market funds, already searching for high-quality places to put investors' cash, would be hurt, investors argue, if interest rates fell any lower than they are now. The potential damage to money market funds is one of the biggest reasons why the Fed might try to avoid cutting the interest rate on excess reserves.