S&P 500 rebounds as investors become optimistic about tax reform

We never hold on for the last nickel. I think you make a big mistake when you do that. We never assume something will go past its fair value. We’ll let someone else make the last dollar or two. We’ll always sell too soon. – Seth Klarman, hedge fund manager

Both the Dow Jones Industrial Average and the S&P 500 Index snapped their two-week losing streak as investors regained hope that tax cuts and tax reform would be implemented on a timely basis. The Nasdaq Composite Index also closed higher as technology stocks sprang back to life. With a paucity of economic data last week and only a few quarterly earnings reports of any consequence, the focus was once again on President Trump, the Federal Reserve and geopolitics. Early in the week, the U.S. and South Korea participated in military exercises that seemed to take on added importance in light of recent tensions between the U.S. and North Korea. President Trump also commented that he’d be willing to let the government shut down if appropriations are not made for his much-talked about border wall. He followed those remarks with a statement that expressed doubts about reaching a deal to renegotiate NAFTA. While the stock market did not take kindly to these comments, it did rebound strongly when it was revealed that the administration plans to forge ahead with tax cuts and tax reform. In fact, President Trump will begin to campaign for tax reform this week. Any significant progress on this initiative should help bolster the stock market, which has been wavering lately as doubts have arisen about the viability of Trump’s pro-growth agenda of tax reform, deregulation and increased infrastructure spending. The other important event last week was the Economic Policy Symposium where Fed Chair Janet Yellen and European Central Bank (ECB) President Mario Draghi were scheduled to speak. Yellen disappointed investors by offering no clues about the Fed’s future plans for monetary policy, but, instead, emphasized that the financial system was sound ten years after the financial and housing crisis. Draghi noted that the global economic recovery has firmed and is gradually improving but that additional monetary stimulus is still needed. Their comments had only minimal effect on the markets, which generally traded flat on Friday.

Last Week

Housing data last week was soft as new home sales in July dropped to a 7-month low and existing home sales fell to their lowest monthly level of the year. Although demand is strong for both new and existing homes, a lack of inventory of homes for sale has led to higher prices. Home prices rose almost 7% during the quarter. U.S. durable goods orders plunged nearly 7% in July, which was more than expected, and the biggest drop since August 2014.  The decline offset the increase registered in June and was the result of a huge drop in orders for transportation equipment. Weekly jobless claims were 234,000, below expectations of 238,000, and consistent with a continued strong labor market.

For the week, the Dow Jones Industrial Average rose 0.6% to close at 21,813 while the S&P 500 Index increased 0.7% to close at 2,443. The Nasdaq Composite Index added 0.8% to close at 6,265.

This Week

The most important piece of economic data this week will be the August employment report, which is expected to show that about 175,000 jobs were created and that the unemployment rate remains at 4.3%. The second reading for second quarter GDP is expected to be slightly higher at 2.7% versus 2.6% that was initially reported and the August Chicago Purchasing Manager’s Index (PMI) should come in at about 60, a very high level and comfortably in expansion territory. Automobile sales for August will also be reported as well as the Michigan consumer sentiment index, which is expected to indicate a high level of confidence among consumers.

It will be another relatively quiet week for earnings and the most prominent companies on the calendar include H&R Block, Best Buy, Bob Evans Farms, Analog Devices, Campbell Soup and Dollar General.

Portfolio Strategy

Many stock market pundits believe that the market is currently overvalued by almost every standard valuation measure. The most commonly used valuation measure, the price earnings ratio, is currently at about 18 times estimated earnings for 2017 and 17 times expected earnings for next year. While these valuation measures are higher than the historical average price earnings ratio of 14 or 15, they do not take into account the fact that interest rates are also at historical lows. The current yield of the 10-year Treasury is only 2.17% and the annualized rate of inflation for the past year has been below 2%. This low yield is more than 50% below the historical average of 4.6% for the 10-year Treasury. Interest rates do not only affect the economy; they affect the stock market as well. Higher interest rates are a negative for stock prices since they reduce the discounted present value of the cash flow from stocks, such as earnings and dividends. Investors would not pay as much for these future cash flows if interest rates were higher, say 4% or 5%. But with interest rates at 2% for a 10-year Treasury and lower than that for shorter maturities, investors will pay more for these future cash flows. For value investors with a long-term time horizon, stocks are not overvalued relative to bonds and, in fact, may be more attractively priced based on the possibility of future earnings and dividend growth.