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Stocks close lower as global central banks become hawkish

Investors should be skeptical of history-based models. Constructed by a nerdy-sounding priesthood using esoteric terms such as beta, gamma, sigma and the like, these models tend to look impressive. Too often, though, investors forget to examine the assumptions behind the models. Beware of geeks bearing formulas. – Warren Buffett

What a difference a week makes. All of the gains that the Nasdaq Composite Index posted the previous week, it gave back last week as investors once again took profits in high-flying technology stocks. Although both the S&P 500 Index and the Dow Jones Industrial Average also closed lower, their losses paled in comparison to the 2% drop in the Nasdaq. What triggered the sell-off in the technology sector, other than lofty valuations, might have been comments made by global central banks. The most hawkish remarks were made by Mario Draghi, the president of the European Central Bank (ECB), who talked about the strengthening and broadening economic recovery in the euro zone and intimated that the need for monetary stimulus may be coming to an end. In a speech in London, Federal Reserve Chair Janet Yellen also commented about the Fed’s plans to gradually reduce the securities on its balance sheet. She was confident that economic growth would improve and sang the praises of banks, saying that they were much stronger now and that another financial crisis is probably not likely in our lifetime. On the heels of her remarks, the yield on the 10-year Treasury rose from 2.15% to 2.30%. One of the underpinnings of this bull market has been the easy monetary policies of global central banks. As global central banks begin to tighten and interest rates begin to rise, stocks that are trading at rich valuations may be vulnerable. For this reason, technology stocks sold off last week and bank stocks surged as financials trade at less than the market multiple and would benefit from higher interest rates. The strength in bank stocks was also due to the fact that the biggest U.S. banks passed the second part of the Federal Reserve’s stress test that allows them to return money to shareholders. With the exception of Capital One Financial, which must resubmit its plan to increase capital, the Fed did not object to any of the other banks’ plans to hike dividends or repurchase stock. With reasonable valuations, bank stocks should continue to benefit from strong capital returns, rising dividends, regulatory reforms and the distinct possibility of more interest rate hikes. Last week marked the end of the first half of the year and the increased market volatility that we saw may be a sign of things to come in the second half.

Last Week

Economic data last week was mixed. Durable goods orders in May fell much more than expected and registered the biggest drop in 6 months. Business investment lagged significantly as many businesses are taking a wait-and-see approach on health care reform as it is one of their biggest expenses. Pending home sales in May fell for the third straight month as there are not enough homes for sale to satisfy demand. Final gross domestic product (GDP) for the first quarter was revised higher to 1.4% from 1.2% on higher consumption. The Chicago Purchasing Manager’s Index (PMI) rose to its highest level since May 2014, a sign of continued manufacturing strength.

For the week, the Dow Jones Industrial Average slipped 0.2% to close at 21,349 and the S&P 500 Index dropped 0.6% to close at 2,423. The Nasdaq Composite Index declined 2% to close at 6,140.

This Week

The June employment report is expected to show that 185,000 new jobs were created compared to only 138,000 in May and that the unemployment rate remained the same at 4.3%. The ISM manufacturing index for June should improve and be solidly in expansion territory. The Federal Reserve will also release minutes from its June meeting and they will likely strike a cautious tone about the economy and any future interest rate hikes.

Due to the holiday shortened week, there are only a handful of companies scheduled to report quarterly earnings and none of them are household names.

Portfolio Strategy

In one of the least volatile first six months of any year for the stock market, the S&P 500 Index posted a total return of 9.3%. While this is historically an excellent return for an entire year, we still have six months left to add to the gains. However, there are several potential land mines out there that could disrupt the stock market going forward. The price of crude oil tumbled 20% from its most recent high and only recovered slightly last week. It’s true that weak oil prices have been more the result of excess supply than tepid demand, but it also could be a sign of slowing economic growth. Other commodities have been under pressure as well. Inflation expectations have also been declining even as the Federal Reserve raised interest rates in June and plans to raise them again at least one more time this year. The Fed’s preferred measure of inflation, the personal consumption expenditures (PCE) index, fell to 1.4% in the 12 months through May, below the Fed’s target of 2%. Although the yield on the 10-year Treasury rose last week to 2.30%, the current yield curve or the difference between short-term rates and long-term rates has flattened out. Investors in Germany and Japan have been buying U.S. government bonds for their comparatively higher yields, causing bond prices to rise and yields to fall. But continued low yields in the bond market may also be signaling slower growth for the economy and weaker corporate profits. Absent tax cuts and tax reform and increased fiscal spending, such a scenario could be problematic for the stock market. Finally, the lack of volatility in the first half is highly unusual and last week’s action in the Nasdaq could portend more sizable ups and downs in the second half. The biggest risk to the market appears to be slowing global growth in the face of weaker commodity prices and persistently low inflation at the same time that global central banks are removing monetary stimulus.