Stocks close at all-time highs on strong economic data

All intelligent investing is value investing – acquiring more that you are paying for. You must value the business in order to value the stock. – Charlie Munger

As investors continue to be optimistic and hopeful about President Donald Trump’s proposed economic agenda of deregulation, corporate tax cuts and fiscal stimulus, there was hard evidence of an improving economy in the form of better-than- expected economic data last week. While talk of Trump’s so-called “phenomenal” tax plan propelled stocks to record highs the previous week, it was strong economic data that did the heavy lifting this past week. All of the major stock averages closed at all-time highs with gains of at least 1.5% across the board. As long as the economy continues to improve, investors are willing to bid stocks higher and wait for Trump’s pro-growth policy initiatives to be enacted. Retail sales in January were much stronger than expected as every major retail sector reported higher sales except the automobile sector, whose sales have historically fallen after the Christmas season. There also was evidence of a rebound in manufacturing. The Empire State Index of manufacturing activity in New York jumped to a 2-year high in February and the Philadelphia Fed index soared to a 33-year high, well-above forecast. Both regional indicators of manufacturing conditions suggest that the industrial sector is strengthening. Inflation data last week also pointed to firming prices and even prompted Fed Chair Janet Yellen to say it would be “unwise” with the recent rise in inflation and economic growth to wait too long before raising interest rates. As a result, the odds of a rate hike in March increased. The rise in business confidence was also evident in the National Federation of Independent Business (NFIB) small business index as it reached its highest level since December 2004. As long as economic data remains solid and  corporate earnings continue to improve, market sentiment should remain bullish, although a temporary pullback in stock prices cannot be ruled out.

Last Week

Both the producer price index (PPI) and the consumer price index (CPI) rose 0.6% in January, twice as much as expected, due to rising energy costs. In the 12 months ended in January, the PPI increased only 1.6% while the CPI rose 2.5% over the same time period. Leading economic indicators in January jumped 0.6% and confirmed a strengthening economy. While U.S. housing starts fell slightly in January, permits increased, signaling more units to be built in the months ahead. Weekly jobless claims also increased by 5,000 to 239,000 but remain at very low levels consistent with a strong labor market.

In testimony before Congress last week, Fed Chair Janet Yellen said that interest rates could be raised sooner rather than later but that any rate hikes would likely be gradual. She also acknowledged that economic growth has been disappointing but that it wasn’t the fault of the Federal Reserve.

For the week, the Dow Jones Industrial Average rose 1.7% to close at 20,624 while the S&P 500 Index gained 1.5% to close at 2,351. The Nasdaq Composite Index jumped 1.8% to close at 5,838.

This Week

The markets will be closed on Monday in observance of President’s Day and the rest of the week promises little in the way of economic data. January new and existing home sales will be higher than those reported in December and in keeping with a steadily improving housing sector. The final University of Michigan sentiment index for February should remain at a level that shows consumers remain confident in the prospects for the economy. The Federal Reserve releases minutes from its January policy meeting.

Retailers will dominate the quarterly earnings reports this week as Home Depot, Wal-Mart, Macy’s, TJX Cos., Kohl’s, Nordstrom and the Gap are all scheduled to report. Other companies on the agenda include Chesapeake Energy, Southern Co., Medtronic, HP and Newmont Mining.

Portfolio Strategy

With wage growth accelerating and inflationary pressures building, it appears that the Federal Reserve will probably raise interest rates two or three times this year. In her testimony before both the House and the Senate last week, Fed Chair Janet Yellen seemed to be leaning toward this many rate hikes. If proposed tax cuts and infrastructure spending touted by the Trump administration become a reality, inflation could become even more worrisome. Much of the damage to bonds has already been done as the yield on the 10-year Treasury has risen more than a full percentage point since last summer. (Bond yields move inversely to prices). During this time, intermediate and longer term Treasuries and high quality corporate bonds have lost about 3% in market value. But gradually rising interest rates can be beneficial over time as interest and maturing bonds are reinvested at those higher rates, providing a higher income payout. Interest rates aren’t likely to keep rising at the same rate that they have, either, as most economists expect the 10-year Treasury yield to range between 2.5% and 3.0% this year. Even so, investors would be wise to shorten the duration of their fixed income portfolios to minimize any potential losses from rising interest rates. A mix of both core bond funds with intermediate-term maturities as well as short-duration bond funds would help offset any stock market volatility and help preserve principal in a rising interest rate environment. A duration of about five years for a fixed income portfolio seems to provide a reasonable compromise between higher interest rates and increased stock market volatility.