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North Korea fears sink stocks, S&P 500 falls 1.4%

We have, as human beings, a storytelling problem. We’re a bit too quick to come up with explanations for things we don’t really have an explanation for. – Malcolm Gladwell, journalist, author and speaker

The Dow Jones Industrial Average didn’t spend much time above the 22,000 milestone. After eclipsing this barrier the previous week, the Dow succumbed to a bout of acrophobia last week and fell 234 points for a decline of 1.1%. The S&P 500 Index and the Nasdaq Composite Index posted even larger percentage losses for the week. Any number of explanations could be provided for the drop, but the most likely one involved news that North Korea was capable of building a nuclear warhead small enough to fit inside a missile. North Korea leader Kim Jong-un also said that it was considering a missile strike aimed at Guam, which prompted President Donald Trump to warn that any threats would be “met with fire and fury like the world has never seen.” We can only hope that this war of words remains just that, but the bluster on both sides offered investors an excuse to lighten their equity positions with the market trading near all-time highs. There were other reasons that could be used to explain the weakness in stocks. Bond guru Jeffrey Gundlach, CEO of DoubleLine Capital, made some bearish remarks about the lofty valuation of the S&P 500 and warned of a possible near-term correction in the market. There were also some red flags last week from a technical perspective. The market breadth, a measure of how many stocks are rising versus the number that are falling, has turned negative and could be a warning sign for the market. Far fewer stocks in the S&P 500 are trading above their 50-day moving average than earlier in the summer and many stocks, including REITs and retail stocks, have entered bear market territory. Lack of progress on Trump’s pro-growth policy initiatives such as tax cuts and tax reform and increased infrastructure spending has frustrated investors who are quickly losing patience that any meaningful legislation will be passed soon or even at all. Finally, stocks are fully valued if not overvalued by many measures and the likelihood of monetary policy tightening by the Federal Reserve are also causes of concern. All of these reasons are plausible explanations for the sell-off in stocks last week, but the only accurate one is that there were more sellers than buyers.

Last Week

Inflation continues to remain under control as evidenced by both the producer price index (PPI) and the consumer price index (CPI) for the month of July. The PPI fell slightly and was less than expected while the CPI edged slightly higher and was also less than expected. Over the past 12 months through July, the CPI has risen just 1.7%, below the Fed’s target of 2%. Job openings hit a record high of 6.2 million in June as small business owners are having a difficult time finding suitable employees. Nevertheless, the National Federation of Independent Business (NFIB) Small Business Index rose and indicated a high level of confidence among small business owners. U.S. productivity rose in the 2nd quarter and was better than expected and mortgage applications also increased as interest rates dropped.

For the week, the Dow Jones Industrial Average fell 1.1% to close at 21,858 while the S&P 500 Index dropped 1.4% to close at 2,441. The Nasdaq Composite Index declined 1.5% to close at 6,256.

This Week

There will be a broad array of economic data on the schedule this week. July import prices are expected to increase slightly and show inflation remains benign. July retail sales are forecast to bounce back with a healthy gain as retailers prepare for the back-to-school shopping season. Housing starts and industrial production for July are expected to be consistent with modest economic growth while the July leading economic indicators should also confirm this trend. The August Michigan consumer sentiment index is expected to show that consumers remain confident about the economy and its prospects.

The Federal Open Market Committee will release minutes from its meeting in July and negotiations are scheduled to begin on the NAFTA (North American Free Trade Agreement) treaty between the U.S., Canada and Mexico.

Retailers will dominate the quarterly earnings reports this week as Home Depot, Target, Wal-Mart Stores, Staples, TJX Companies, Coach and Dick’s Sporting Goods are on the agenda. Other notable companies due to report include Sysco, Deere, Cisco Systems and Applied Materials.

Portfolio Strategy

While rising tensions between the U.S. and North Korea are a concern and something that should not be taken lightly, it is extremely rare that a geopolitical event such as this one would cause the current bull market to end. For this to happen, the U.S. economy would have to be affected and this is highly unlikely given the size of our economy and the fact that second quarter GDP growth was 2.6%, not robust but certainly not approaching recessionary levels either. Most economists expect GDP growth for the full year to be between 2.0% and 2.5% without the benefit of any of President Trump’s pro-growth policies, which are becoming increasingly less likely to pass in 2017. If tax reform and tax cuts were able to be enacted between now and year-end, that would be a shot in the arm for the economy and boost economic growth. In addition to a healthy and vibrant economy, second quarter corporate earnings have also been exceptional, with earnings up 10% compared to estimates of only 6% growth. Earnings should continue to be strong through year-end and, in the final analysis, stock prices are driven by earnings and economic growth, both of which seem more than adequate to keep the bull market in stocks intact. While increased volatility along with the anxiety that it produces will likely be with us for the foreseeable future, investors should stay the course as long as they are comfortable with their investment objective and current asset allocation among stocks, bonds and cash.