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S&P 500, Nasdaq at record highs on earnings, probable Fed rate cut

“Prices are too high” is far from synonymous with “The next move will be downward.” Things can be overpriced and stay that way for a long time…or become far more so. – Howard Marks

Both the S&P 500 Index and the Nasdaq Composite Index closed at record highs last week as a wide range of companies continued to report better than expected quarterly earnings. The Dow Jones Industrial Average, however, closed virtually flat as Boeing weighed on its performance by reporting a huge loss due to soaring costs associated with the grounding of the 737 Max jet. While the second quarter earnings season still has a long way to go, the results so far have been impressive even though expectations were low. With more than 40% of S&P 500 companies having reported their earnings, over 75% of them have exceeded analysts’ estimates. Blue chips such as Coca Cola, United Technologies, Facebook, Alphabet (Google), Starbuck’s and Intel reported revenue and earnings that were better than expected. Despite the negative effects of tariffs and a strong dollar, many companies also raised their guidance on earnings for the balance of the year.  But there are clouds on the horizon as the International Monetary Fund (IMF) lowered its global economic growth forecast for the year from 3.5% to 3.2%. Uncertainties over the length of the trade war between the U.S. and China as well as worries over Brexit, Britain’s exit from the European Union (EU), could be headwinds for stocks in the second half of the year. For these reasons, the Federal Reserve and the European Central Bank (ECB) are prepared to provide monetary stimulus if needed to sustain economic growth. The Fed is all but certain to lower the federal funds rate to 2% to 2.25% next week while ECB President Mario Draghi said that the ECB plans to leave interest rates at “present or lower levels” at least through the first half of 2020. The market also received good news last week on the trade front as face-to-face talks between U.S. and Chinese negotiators are scheduled to occur in the coming week. With another slew of corporate earnings reports, a Federal Reserve meeting and the July employment report on tap for this week, investors will have a plethora of potential market-moving data to process.

Last Week

The U.S. economy grew by 2.1% in the second quarter, better than the 1.8% growth that was expected but less than the 3.1% GDP in the first quarter. The increase was largely due to strong consumer spending as business investment remained weak. Durable goods orders for June were also better than expected and core capital goods orders, a key measure of business spending, rebounded. June existing home sales declined and were less than forecast despite low mortgage rates and a strong labor market.

For the week, the Dow Jones Industrial Average edged up 0.1% to close at 27,192 and the S&P 500 Index rose 1.7% to close at 3,025. The Nasdaq Composite Index surged 2.3% to close at 8,330.

This Week

The July employment report is expected to show that about 160,000 new jobs were created and that the unemployment rate remains unchanged at 3.7%. The ADP report on private payrolls is expected to show similar job gains. The July Purchasing Manager’s Index (PMI) for manufacturing is forecast to be flat and just barely in expansion territory above the 50 threshold. The July consumer confidence index and the University of Michigan consumer sentiment index should remain at high levels. Both June construction spending and factory orders are forecast to post modest increases after declining in May.

The Bank of Japan (BOJ) meets to review its monetary policy and is widely expected to keep its benchmark interest rate at negative 0.1%.

It will be another busy week for earnings reports as nearly one third of S&P 500 companies are due to report. Among the most prominent are Procter & Gamble, Eli Lilly, Merck, Pfizer, Amgen, Apple, Automatic Data Processing, Qualcomm, General Electric, General Motors, Berkshire Hathaway, MetLife, Verizon, Exxon Mobil and Chevron.

Portfolio Strategy

In all likelihood the Federal Reserve will cut the federal funds rate by 25 basis points this week as a pre-emptive measure to sustain growth in the economy. (A basis point is one hundredth of one percent). Although second quarter GDP was slightly better than anticipated, it was considerably less than in the first quarter as there were clear signs that tariffs and trade tensions are taking a toll on exports and business investment. It was strong consumer spending, the best since the fourth quarter of 2017, that enabled growth to be as good as it was in the second quarter. With a tight labor market that has shown improving wage gains and strong consumer confidence, it is no wonder that consumption has been solid. Inflation remains stubbornly low, though, as the core personal consumption expenditures (PCE) index has been running consistently below the Fed’s target of 2%. This anomaly gives the Fed room to ease in the face of increased risks associated with the trade war with China, Brexit and a slowing global economy.     The bond market has reflected the slowdown in growth and the lack of inflation as the yield on the 10-year Treasury has slipped below 2.10%. A 25 basis point cut in rates seems appropriate for now, but the Fed will probably be open-minded about any further cuts and will let economic data dictate their next move.