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S&P 500, Nasdaq close at record highs on earnings, holiday shopping optimism

Individuals who cannot master their emotions are ill-suited to profit from the investment process. – Benjamin Graham

The stock market has historically been strong during Thanksgiving week and it did not disappoint investors this past week. Fueled by optimism that this will be a strong holiday shopping season, both the S&P 500 Index and the Nasdaq Composite Index closed at record highs on Friday. For the first time ever, the S&P 500 closed above 2,600 as better than expected quarterly earnings and continued hope for a tax reform package also helped boost stocks. The Dow Jones Industrial Average failed to set a new all-time high by only 33 points. In what has become a common theme this earnings season, the majority of companies once again beat profit expectations last week. With almost all of the S&P 500 companies having reported third quarter earnings, about 75% of them have surpassed estimates with average profit growth of 6.25% on a year-over-year basis. Last week’s winners included Hormel Foods, Dollar Tree, Lowe’s and Deere, all of which reported earnings that beat forecasts. Even retailers such as Macy’s, Nordstrom and Kohl’s got into the act, which prompted investors to feel downright giddy over prospects of a strong holiday shopping season. Since consumer spending accounts for about two-thirds of gross domestic product, it was no surprise that retail stocks rebounded and the rest of the stock market followed suit. Minutes from the most recent Federal Open Market Committee (FOMC) meeting simply confirmed the stock market’s optimism and positive sentiment as well. They showed that Fed officials were sanguine that economic growth would continue to improve but were divided on whether or not inflation would begin to pick up. Despite this disagreement on inflation, the markets are betting that a December interest rate hike is a near-certainty. The Fed’s biggest worry was that a severe correction in the stock market might have damaging effects on the economy. The market has not had as much as a 5% correction in over a year and the prolonged lack of volatility will only make the next correction that much more painful. But with a solid U.S. economy, improving global growth and historically low interest rates, what triggers a correction in stocks is anybody’s guess.

Last Week

Leading economic indicators, which are a weighted average of 10 indicators that measure economic activity, were much better than expected in October as layoffs declined, job hires increased, stocks rose and the housing market rebounded. Existing home sales in October increased more than expected but a shortage of homes has pushed prices up, making many homes unaffordable. October durable goods orders fell more than expected and core capital goods orders, a measure of business investment, also slipped. These orders have been strong this past year and this decline could be temporary as companies wait for the outcome of tax reform. The final monthly University of Michigan consumer sentiment index improved and was the second best reading in 13 years.

When newly appointed Federal Reserve Chairman Jerome Powell takes the helm in February after almost certain confirmation this week, Fed Chair Janet Yellen will leave the central bank and not remain a member of the board of governors.

For the week, the Dow Jones Industrial Average added 0.9% to close at 23,557 while the S&P 500 Index also gained 0.9% to close at 2,602, an all-time high. The Nasdaq Composite Index jumped 1.6% to close at 6,889, also an all-time high.

This Week

The preliminary third quarter gross domestic product (GDP) reading is expected to be 3.2%, compared to 3.0% in the second quarter. October new home sales are forecast to be less than in September but still strong while the November Chicago Purchasing Manager’s Index (PMI) is also expected to slip from the prior month’s reading but remain above 60, a level associated with strong expansion. Construction spending in October is also expected to post a healthy gain.

Federal Reserve Chair Janet Yellen will provide testimony on the economic outlook before the congressional Joint Economic Committee and the Fed will release its final beige book for the year.

During this last week of earnings season, the most prominent companies that are on the agenda are Autodesk, Kroger, American Eagle Outfitters, Tiffany and Barnes & Noble.

Portfolio Strategy

Over the last several years, stocks have posted impressive returns due to strong earnings growth by corporations as well as an accommodative Federal Reserve that has kept interest rates low. During this time, the market has experienced extremely low volatility marked by an absence of any sizable corrections. The stock market plunged in February 2016 by 15% but quickly rebounded and erased all of its losses. Right now equity valuations aren’t cheap as the S&P 500 Index trades at about 18 times estimated earnings for 2018, above the historical average of 15 to 16. While stocks are not necessarily due for a fall, now is an excellent time to review one’s asset allocation to determine whether or not there is too much risk in the portfolio. Attempting to time the market is a losing proposition so investors have to be able to withstand meaningful corrections based on their investment allocation and be mentally prepared if their portfolio declines in value. Equating percentage declines in stocks with actual dollars lost might prompt investors to reevaluate their risk tolerance and adjust their portfolio allocation accordingly. The key to building wealth is time in the market and not timing the market. In the event of a stock market decline, it’s important to remain calm and not to sell stocks but to tap into fixed income investments when cash is needed, which enables investors to ride out the decline and participate in the eventual recovery. During the 10-year period from 2000 to 2010, stocks suffered through two bear markets and basically went nowhere for the entire decade. But for the next seven years, the stock market has more than doubled and investor’s patience has been rewarded. These outsized returns, though, have come with no meaningful declines, which is not normal and suggests that an inevitable drop in stock prices when one does occur could be more severe. With equity valuations already stretched, future expected returns are likely to be lower and volatility is likely to be higher. Investors should take this into consideration when reviewing their financial plans and have realistic expectations going forward.