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Stocks rally to post modest losses in volatile week

Values aren’t fixed; they move in response to changes in the economic environment. Thus, cyclical considerations influence an asset’s current value. Value depends on earnings, for example, and earnings are shaped by the economic cycle and the price being charged for liquidity. – Howard Marks

The S&P 500 Index plunged nearly 2% on Wednesday as political jitters in Washington reached a crescendo, but stocks rebounded on strong quarterly earnings results to end the week with only modest losses. Both the Dow Jones Industrial Average and the Nasdaq Composite Index also slipped last week. It marked the second consecutive week that these three major stock averages were lower, albeit only slightly. It’s been one fiasco after another with the Trump administration and reports that a memo by former FBI Director James Comey on a conversation he had with President Trump on halting the investigation into former aide Michael Flynn sent stocks tumbling midweek. To finally determine whether or not there was possible collusion between the Trump campaign and Russia, former FBI head Robert Mueller was named as special counsel to lead the investigation. All of this turmoil only diverts attention away from implementing Trump’s pro-business policies aimed at stimulating economic growth through tax cuts, deregulation and increased infrastructure spending. The longer this drama in Washington plays out, the more likely this agenda becomes postponed, making stocks vulnerable for a correction. But stocks are influenced more by earnings and economic data than politics and that proved to be the case again last week as strong earnings and favorable economic reports buoyed the market. Bucking a weak earnings season for retailers, Wal-Mart Stores and Gap beat earnings estimates while agriculture equipment manufacturer Deere and semi-conductor equipment maker Applied Materials also topped earnings expectations and issued upbeat guidance for the rest of the year. Oil prices also increased last week after Saudi Arabia and Russia agreed to extend a production cut until March 2018 and homebuilder sentiment in May rose to its highest level since the recession. With earnings season winding down, economic data will have to do the heavy lifting now to keep the market afloat.

Last Week

After a strong first quarter, housing starts in April edged lower and were below expectations. The Empire State manufacturing index for the New York area also fell into negative territory in May while the Philadelphia Fed manufacturing index soared from its April reading. U.S. industrial production was better than expected in April and grew at the fastest pace in more than three years. Weekly jobless claims fell 4,000 to 232,000, fewer than expected, as the labor market remains strong with very few layoffs.

St. Louis Federal Reserve President James Bullard commented that the Fed’s plan to raise interest rates two more times this year may be too fast, given the fact that macroeconomic data recently has been relatively weak since its meeting in March.

For the week, the Dow Jones Industrial Average fell 0.4% to close at 20,804 and the S&P 500 Index also lost 0.4% to close at 2,381. The Nasdaq Composite Index declined 0.6% to close at 6,083.

This Week

The second estimate of first quarter gross domestic product (GDP) is expected to be the same or 0.7%. Both new and existing home sales in April are expected to be consistent with those reported in March while April durable goods orders should be less than those released last month. The Federal Open Market Committee (FOMC) releases minutes from its policy meeting held in May.

President Trump has meetings scheduled on Thursday in Brussels with European Union (EU) presidents   as well as with NATO leaders.

Retailers will headline this weeks’ profit reports again as Lowe’s, Best Buy, Costco, Williams-Sonoma, Tiffany and Dollar Tree are due to report earnings. Other prominent companies on the agenda include AutoZone, HP, Medtronic and Toll Brothers.

Portfolio Strategy

In a stock market that has remained relatively calm of late, the nearly 2% decline in the S&P 500 Index on Wednesday is a reminder that stocks can be volatile. Treasury prices rose and yields fell on that day (bond prices move inversely to yields) and the yield on the 10-year Treasury has now fallen to 2.24% after reaching a high of 2.65% in mid-March. With all of the turmoil swirling around Washington, investors sought a safe haven in Treasuries, even though the stock market managed to recoup most of its losses by week’s end. The investigation into President Trump’s alleged campaign ties with Russia could drag on for months, creating a cloud that could delay passage of meaningful tax reform and infrastructure spending legislation. With economic growth having slowed to less than 1% in the first quarter, the economy is in need of additional stimulus. The Federal Reserve is poised to raise interest rates in June, which could have the unintended consequence of slowing the economy even further. Although first quarter earnings have been excellent and responsible for much of the strength in the stock market, the pro-growth policies of the Trump administration have also played a key role in the market’s ascent since the election. There could be more volatile days like Wednesday in the stock market’s future, which is why investors should play defense with the fixed income portion of their portfolio. Investment grade corporate bonds have a yield advantage over Treasuries and typically do not have the credit risk that lower quality bonds have. Many of these bonds with maturities in the seven to ten-year range have yields in excess of 3%. For those investors in a high tax bracket, high quality, intermediate-term municipal bonds make the most sense. Either way, bonds provide a cushion and a way to hedge the risk of a portfolio when stock market volatility increases.