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S&P 500 ends volatile week flat despite strong earnings

You do things when the opportunities come along. I’ve had periods in my life when I’ve had a bundle of ideas come along, and I’ve had long dry spells. If I get an idea next week, I’ll do something. If not, I won’t do a damn thing. – Warren Buffett

If you like the thrill of a roller coaster ride, last week’s stock market action was for you. After a negative start to the week, the Dow Jones Industrial Average rebounded by 548 points on Tuesday, only to plunge by 327 points on Thursday and then relinquish a 200-point gain on Friday to close modestly lower. For all its ups and downs for the week, the broad-based S&P 500 Index wound up rising less than a point when the closing bell rang on Friday. Corporate earnings for the third quarter certainly couldn’t be blamed for the volatility as they have been strong. With just 15% of S&P 500 companies having reported earnings so far, over 80% of them have beaten analysts’ estimates. Financials such as Bank of America, Goldman Sachs and Morgan Stanley continued to post impressive results and other blue chips such as Johnson & Johnson, Honeywell and Procter & Gamble followed suit. However, investor concerns over rising interest rates, geopolitical tensions and a potential slowdown in the global economy weighed on sentiment and raised anxiety levels. Minutes from the most recent Federal Reserve meeting showed that Fed officials are convinced that they need to tighten monetary policy to prevent the economy from overheating. They contend that a gradual approach to raising interest rates would balance the risk of tightening too fast and causing the economy to weaken, and tightening too slowly, which could lead to inflationary pressures. In all likelihood, the Fed will stay the course and raise the federal funds rate in December along with three additional increases next year. This aggressive forecast has caused short-term yields to rise and the 2-year Treasury yield ended the week at 2.92%, up from about 1.60% a year ago.

Last Week

Retail sales in September increased less than expected due to the effects of Hurricane Florence and geopolitical trade tensions. Industrial production in September was better than expected and manufacturing was up over 5% year-over-year, the biggest gain in nearly 8 years. September leading economic indicators posted a moderate increase, a 12th straight month of gains, which suggests strong growth for the balance of the year. The labor market remains strong as weekly jobless claims fell to the lowest level since 1973.

For the week, the Dow Jones Industrial Average rose 0.4% to close at 25,444 and the S&P 500 Index edged higher by less than a point to close at 2,767. The Nasdaq Composite Index declined 0.6% to close at 7,449.

This Week

New home sales in September are expected to rise modestly while durable goods orders are expected to fall slightly after posting a solid increase in August. The advance third quarter gross domestic product (GDP) is forecast to increase by 3.3% compared to 4.2% in the second quarter. The October University of Michigan consumer sentiment index should match last month’s high reading.

The European Central Bank (ECB) is expected to leave its key interest rate unchanged at -0.4%.

This will be a busy week for earnings and the most notable companies due to report include McDonald’s, Visa, 3M, United Technologies, Caterpillar, Ford Motor, Boeing, Union Pacific, Microsoft, Alphabet (Google), Amazon, Intel, Verizon, AT&T, Merck, Bristol Myers Squibb and ConocoPhillips.

Portfolio Strategy

With the recent rise of the 2-year Treasury yield to over 2.90%, yields on short-term bonds are far more attractive than they have been in a long time. The spike in short-term yields has also made these securities more appealing when compared with longer-term issues. The current yield on the 10-year Treasury is   3.20%, only 28 basis points higher than the 2-year Treasury yield. (A basis point is one hundredth of a percentage point). The increase in short-term bond yields has also made these securities more attractive relative to dividend-paying stocks. The current yield of the S&P 500 Index is currently slightly less than 2%. The big advantage of shorter-term bonds is that they are less sensitive to changes in the level of interest rates than longer-term bonds. For this reason, it is important to reduce the duration risk of a fixed income portfolio by shortening its average maturity. In a rising interest rate environment such as the one we have now, the interest payments and maturity proceeds from short-term bonds can be reinvested more quickly at higher yields. Money market funds also benefit from rising interest rates as their yields rise without any loss of principal. Many money market funds yield over 2% and their year-to-date performance has been slightly positive, unlike most intermediate and longer-term bond funds. Ultra-short term bond funds with average maturities of one year have also posted positive returns this year and yield about 2.5%. Bond funds with 2 to 3 year average maturities are another good alternative with yields above 3%. With the Federal Reserve on track to gradually raise interest rates, positioning a fixed income portfolio defensively by including short-term bond funds can help protect the principal value against losses.