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Dow up 8th straight week on optimism over China trade deal

Buy a stock the way you would buy a home. Understand and like it such that you’d be content in the absence of any market. – Warren Buffett

All three major stock averages posted solid gains last week despite weaker than expected economic data and mixed quarterly earnings reports. The Dow Jones Industrial Average closed higher for the eighth consecutive week and turned in the best performance with an increase of 3.1%. The stock market strength was somewhat of a surprise as December retail sales registered their biggest monthly drop since September 2009 and were much worse than expected. Expectations were for stronger consumer spending growth since job gains have been solid, wage growth has been improving and gasoline prices are lower. Industrial production also fell in January for the first time in eight months, lending credence to the belief that the economy was slowing. Earnings reports were also not consistent as Cisco Systems beat revenue and earnings estimates but Coca Cola and John Deere released disappointing results and offered weak guidance. On a positive note, though, another government shutdown was avoided as the House and Senate agreed to compromise on border security and President Trump signed a funding bill on Friday. He also declared a national emergency over the border and said he would find other sources of funds to pay for the barrier along the southern border with Mexico. Although averting another government shutdown eliminated one uncertainty, resolution of the trade war between the U.S. and China remains elusive. There were unconfirmed reports last week that trade talks were progressing well and that both sides were getting closer to reaching an agreement. In fact, President Trump commented that the U.S. and China were closer than ever before to a trade deal. Talks will resume this week in Washington and optimism remains high that the two countries will sign an agreement by the March 1st deadline. It was this positive sentiment over a potential deal that fueled much of last week’s rally but much of the good news may already be priced into the stock market.

Last Week

As expected, inflation remains under control as the producer price index (PPI) in January fell slightly due mostly to lower energy prices and has increased only 2% over the past year. The January consumer price index (CPI) was unchanged as cheaper gasoline offset increases in rent, food and medical care. Import prices in January were also weak, falling for the third month in a row as a strong dollar reduced the cost of foreign goods. The University of Michigan consumer sentiment index rebounded strongly in February due to the end of the government shutdown and low inflation expectations.

For the week, the Dow Jones Industrial Average jumped 3.1% to close at 25,883 and the S&P 500 Index climbed 2.5% to close at 2,775. The Nasdaq Composite Index rose 2.4% to close at 7,472.

This Week

It will be a relatively quiet week for economic data as December existing home sales are expected to top those reported in November and January leading economic indicators are forecast to be up slightly after declining in December. Durable goods orders for December are also expected to show an improvement.

The Federal Open Market Committee (FOMC) will release the minutes from its January meeting and investors will be looking for additional information on the Fed’s willingness to be “patient” with regard to any future interest rate hikes.

Among the most notable companies scheduled to report earnings this week are Berkshire Hathaway, Devon Energy, Consolidated Edison, Southern Co., WalMart, Medtronic, CVS Health, Genuine Parts, Fluor, Newmont Mining, Agilent Technologies and Analog Devices.

Portfolio Strategy

Both the stock market and the bond market have been rising since the start of the year and the reasons for their strength are entirely different. From its low on Christmas Eve, the S&P 500 Index has climbed 18% and is up 11% including dividends so far this year. In the U.S. Treasury market, yields have steadily fallen over the last two and a half months. (Bond prices move inversely to yields). The yield on the 10-year Treasury has declined from 3.00% to 2.66% while the 2-year Treasury yield has dropped from 2.80% to 2.52% during this time period. The strength in the stock market can be attributed to four things: optimism that a U.S.-China trade deal will be reached, a patient and accommodative Federal Reserve, continued economic growth in the U.S. and China and better than expected fourth quarter earnings growth. The bond market, on the other hand, has been pricing in much slower economic growth with little or no inflation along with the possibility of a recession. The flattening yield curve, which currently shows a difference of only 14 basis points between the 2-year Treasury (2.52%) and the 10-year Treasury (2.66%), is a worrisome sign that suggests a slowing economy. The surprisingly weak retail sales report in December raised a lot of eyebrows and raises concerns that GDP growth may indeed be less that originally forecast. While fourth quarter earnings have grown 16%, first quarter earnings are expected to actually decline for the first time in three years. Stocks have rallied in the face of a projected earnings slowdown, which could be problematic in April when first quarter earnings are released. For this reason, it’s imperative that the U.S. and China reach a trade deal to ensure continued economic and corporate profit growth. Time will tell whether the stock market or the bond market is right about the near term direction of the economy.