Owning the stock market over the long term is a winner’s game, but attempting to beat the market is a loser’s game. – John C. Bogle
The major stock averages resumed their march higher last week and all three closed within a half-percentage point of their all-time closing highs. The Dow Jones Industrial Average eclipsed the 29,000 mark for the first time ever but fell back at Friday’s close. But the week was not without volatility as tensions between the U.S. and Iraq escalated after the killing of Iran’s top military commander. After Iran attacked a U.S. air base in Iraq on Tuesday night, S&P 500 futures plunged in after-hours trading only to rebound at the open of trading on Wednesday when it was learned that there were no U.S. casualties. President Trump said that it appeared that Iran was “standing down” after the attack and he announced that the U.S. would impose new economic sanctions on Iran as punishment. Investors were relieved that the attacks did not target any oil infrastructure and oil prices fell after initially spiking. Since the U.S. is now the world’s biggest oil producer, the prospect of a spike in oil prices is much lower and its effect on the U.S. economy is minimal. While tensions between the two countries eased after the attacks, Iran said that it would not abide by the uranium-enrichment limits established by the 2015 nuclear deal. It’s unlikely that this is the last time we’ve heard from Iran even as a sense of calm seemed to emerge. The other significant news last week was the release of the December employment report on Friday, which showed that 145,000 new jobs had been created and that the unemployment rate remained at 3.5%. The jobs total was less than the 160,000 number that was expected and wages grew by only 2.9% on a year-over-year basis, which was also disappointing. But the silver lining in the slower wage growth was that it’s non-inflationary and should not cause the Federal Reserve to consider raising interest rates. With relatively benign wage inflation, this should benefit corporate earnings since wages are the largest single expense on a corporation’s income statement. The market should be able to withstand geopolitical developments such as the latest Iran flare-up as long as the economy and corporate earnings are solid. That is certainly the case right now for the economy and we’ll get a better read on company profits this week as fourth quarter earnings season begins.
Although the government employment report for December was disappointing, the ADP report for private-sector jobs showed a gain of 202,000, better than expected, and weekly jobless claims fell by 9,000 to 214,000, also better than forecast. The ISM non-manufacturing or services sector index in December was above expectations and solidly in expansion territory. The November U.S. trade deficit also fell to the lowest level during the Trump administration as much of the improvement came at China’s expense and was aided by stabilization in global manufacturing activity.
For the week, the Dow Jones Industrial Average added 0.7% to close at 28,823 while the S&P 500 Index gained 0.9% to close at 3,265. The Nasdaq Composite Index rose 1.8% to close at 9,178.
Inflation data will be on tap this week with the consumer price index (CPI) and the producer price index (PPI) both expected to increase modestly in line with the increases in November. Retail sales in December are expected to show a healthy increase after a slight gain in November as consumer spending remains strong. The University of Michigan consumer sentiment index for January is forecast to be on a par with the final reading in December and at a continued high level.
Fourth quarter earnings season kicks off this week and the week will be dominated by the financials, the most notable being JP Morgan Chase, Citigroup, Bank of America, Wells Fargo, PNC Financial, U.S. Bancorp, Goldman Sachs, Morgan Stanley and Charles Schwab. Other notable companies include Delta Airlines, Alcoa, CSX and UnitedHealth Group.
Fundamentals have generally been fairly good and investors will be able to see just how good when corporations begin reporting their fourth quarter earnings this week. Over the next two weeks, about half of the companies in the S&P 500 will announce their earnings and it is hoped that both the results and the guidance for the full year do not disappoint investors. Stock valuations are stretched by almost every statistical measure so earnings must at least meet expectations to justify current stock prices. Based on expected earnings for 2020, the S&P 500 Index now trades at a price/earnings ratio of about 18.5, above its long-term historical average. The market is also overvalued based on metrics such as price to sales and price to book value. However, based on the earnings yield of the S&P 500 (3.5%), which is the inverse of the price earnings ratio (5.3%) minus the yield of the 10-year Treasury (1.83%), the stock market is considered inexpensive. Relative to both the inflation rate and the current low level of interest rates, the market is not considered expensive. The Federal Reserve’s preferred inflation gauge, the personal consumption expenditures (PCE) index, has been running below its target of 2%. In 2019, stock market gains were almost entirely due to expansion of the price earnings multiple as earnings growth was basically flat. This multiple expansion was aided by the decline in interest rates as the Fed cut rates three times last year. With the Federal Reserve now in a neutral position and unlikely to cut rates this year, stock market gains will have to come from earnings growth, which is expected to be about 5% in 2020. If that turns out to be true, then stocks should produce returns that include dividends in the mid-to-high single digit range.