Hurricanes Harvey and Irma take wind out of stocks, close modestly lower

The game of life is the game of everlasting learning. At least it is if you want to win. – Charlie Munger

The month of September has historically been one of the worst performing months of the year and if last week’s market action is any indication, that trend could continue. All three of the major stock averages declined, with the Nasdaq Composite Index posting the biggest loss as many high-flying technology stocks came back to earth a little bit. Perhaps the most significant near-term risk for the stock market was the possibility of a government shutdown later in September, but that potential pitfall was averted for the time being. President Trump is known for the art of the deal and last week he crossed the aisle to reach one with Senate Minority Chuck Schumer and House Minority Leader Nancy Pelosi. They and fellow Democrats agreed to vote for a Hurricane Harvey aid package and postponement of the debt ceiling deadline until December, preventing a government shutdown for now. The fact that the stock market only closed modestly lower last week is a testament to its strength and resiliency as the market also faced other potential land mines, including Hurricane Irma in Florida, a massive earthquake in Mexico and a deranged dictator in North Korea who has threatened to use a hydrogen bomb. Both the U.S. and global economies, particularly in Europe, continue to do well as evidenced last week by the release of the Federal Reserve’s Beige Book and comments by European Central Bank (ECB) President Mario Draghi. The Beige Book showed that the U.S. economy expanded at a modest to moderate pace in July through mid-August with limited wage pressures and mild inflation. After the ECB decided to leave interest rates unchanged and continue its bond-buying program at least through year-end, Mario Draghi remarked that he was very upbeat on the Eurozone economy and could decide to reduce the purchase of government bonds next year. Another reason for optimism has been earnings, which rose by over 10% in each of the first two quarters and should be strong again in the third quarter, although Hurricanes Harvey and Irma may be responsible for some minor negative adjustments. Generally speaking, analyst expectations for earnings have not been reduced for the rest of this year or for 2018. If these estimates hold true, then the stock market is not as overvalued as many people think and could rally further into year-end.

Last Week

U.S. factory orders fell slightly more than expected in July and recorded their biggest drop since August 2014, although orders for capital goods were stronger than previously reported. This increased business spending was an optimistic sign as the third quarter began. The ISM non-manufacturing or services sector index in August was in line with expectations and solidly in expansion territory. Weekly jobless claims jumped by 62,000 to 298,000, much higher than the 241,000 that were expected, due to a surge in applications in Texas as a result of Hurricane Harvey.

For the week, the Dow Jones Industrial Average fell 0.9% to close at 21,797 while the S&P 500 Index dropped 0.8% to close at 2,461. The Nasdaq Composite Index declined 1.2% to close at 6,360.

This Week

Both the August producer price index (PPI) and the consumer price index (CPI) are forecast to increase modestly but at levels higher than in July. Even with these increases, inflation remains well under control. August retail sales and industrial production are expected to edge up slightly while the Michigan Consumer Sentiment Index for September is expected to remain elevated.

Only three companies are scheduled to report quarterly earnings this week, two of which are Oracle and Cracker Barrel restaurants.

Portfolio Strategy

Not only is the stock market trading near record highs within 1% of its all-time high, but the bond market has also rallied recently, producing higher prices and lower yields. (Bond yields move inversely to prices). The yield on the 10-year Treasury has fallen to 2.06% when it appeared a short time ago that the yield was headed to 3% as global economic growth was accelerating and the Federal Reserve was discussing another interest rate hike and reduction of its $4.5 trillion security portfolio on its balance sheet. But there are a number of factors recently that have caused bond yields to fall. Investors have become nervous over North Korea’s repeated missile launches and have sought safe havens that Treasury bonds and other fixed income securities provide. The devastation that Hurricanes Harvey and Irma bring to Texas and Florida will undoubtedly depress economic growth in the short run and increase jobless claims. Inflation data has also been relatively weak and the Fed’s preferred measure of inflation, the personal consumption expenditures (PCE) index, has been running below 2%, the Fed’s targeted inflation rate. Wage growth has also been modest and disappointing in light of the fact that the labor market is at full employment. Odds of an interest rate hike in December have been falling in recent months and now there is only a one in four chance that one will occur. Continued easy monetary policies by the European Central Bank (ECB) do not help matters, either, as the bond-buying program is expected to remain in place through year-end, keeping interest rates at current low levels. While the passage of tax reform and implementation of tax cuts could cause bond yields to rise as economic growth improves, that is by no means a done deal. With the 10-year Treasury yield hovering around 2%, it is far more likely that bond yields rise than fall from this level. For investors, such a scenario calls for fixed income investments to be relatively short in terms of average maturity and duration as they are less sensitive to changes in interest rates.