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Stocks close at record highs as Fed rate cut appears imminent

If you can follow only one bit of data, follow the earnings – assuming the company in question has earnings. I subscribe to the crusty notion that sooner or later earnings make or break an investment in equities. What the stock price does today, tomorrow or next week is only a distraction. – Peter Lynch

The stock market posted another solid week of gains as the Federal Reserve and Fed Chairman Jerome Powell all but assured investors that an interest rate cut would be coming soon. The Dow Jones Industrial Average closed above the 27,000 mark and the S&P 500 Index topped the 3,000 level for the first time ever. Not to be outdone, the Nasdaq Composite Index also set an all-time closing high as technology stocks continued to rally. In his testimony before both the House and the Senate, Fed Chairman Powell reiterated earlier comments that the Federal Reserve would take appropriate action if necessary to ensure that the economic expansion continues. Uncertainty over trade tensions with China and the prospect of slowing growth have caused concern and made it more likely that the Fed will lower the federal funds rate by 25 basis points at the end of July. (A basis point is one hundredth of one percent). Powell acknowledged that even though GDP growth was a robust 3.1% in the first quarter of the year, there has been a notable slowdown in business investment in the second quarter. He also cited weak inflation below the Fed’s target of 2% as a risk that could persist indefinitely. The release of the Fed minutes from the June meeting only seemed to confirm Chairman Powell’s testimony. Fed officials expressed concern over continued low inflation and pointed out that inflation has been running at only 1.5%, well below its target. After signaling that they would be “patient” with any future interest rate hikes in January, they now believe it would be appropriate to cut rates in order to sustain the current expansion. According to the Fed, reducing rates would help offset the uncertainty caused by the trade war between the U.S. and China. Second quarter earnings season begins in earnest this week, and investors will find out what effect the trade tensions have had on corporate profits.

Last Week

The producer price index (PPI) for June rose slightly and in the 12 months through June, it has risen only 1.7%, the smallest gain since January 2017. The consumer price index (CPI) also edged up slightly in June and the core CPI, which excludes food and energy, has risen 2.1% in the 12 months ending in June. The National Federation of Independent Business released its small business optimism index and it dropped modestly but remained above its historical average.

For the week, the Dow Jones Industrial Average climbed 1.5% to close at 27,332 and the S&P 500 Index added 0.8% to close at 3,013. The Nasdaq Composite Index rose 1.0% to close at 8,244.

This Week

June retail sales and June leading economic indicators are both expected to edge slightly higher and be indicative of an economy that seems to be slowing. The preliminary University of Michigan consumer sentiment index for July is forecast to remain at a high level, which bodes well for continued strength in consumer spending.

While the second quarter earnings season officially began last week, this week brings a torrent of profit reports. Financials will dominate the agenda as Citigroup, JP Morgan Chase, BankAmerica, Wells Fargo, US Bancorp, Goldman Sachs, Morgan Stanley, American Express, Blackrock and Charles Schwab are scheduled to report. Other notable companies include CSX, Union Pacific, Johnson & Johnson, Abbott Labs, UnitedHealth, IBM, Microsoft and Honeywell.

Portfolio Strategy

Economic data and Federal Reserve monetary policy will take a back seat this week to quarterly corporate earnings reports as over fifty S&P 500 companies are due to report. Year-over-year earnings growth in the first quarter was less than 1% and the estimate for the second quarter is for a decline of nearly 3%. This will be the next big risk for the stock market as the trade war with China and slowing growth have almost certainly impacted earnings in a negative way. However, history shows that S&P 500 companies tend to beat analysts’ earnings estimates and the bar may have already been lowered enough for this to happen again. With the stock market trading at all-time highs, there is little margin for error should company earnings fall short. The expectation that the Federal Reserve will lower interest rates at its meeting at the end of July could cushion the downside risk from poor earnings reports. More importantly, investors will be interested in hearing what management has to say about their outlook for earnings for the rest of the year. Companies will probably blame tariffs and a strong dollar if earnings fail to deliver and tariffs are likely to persist unless a trade agreement with China is reached.