The underlying principles of sound investment should not alter decade to decade, but the application of these principles must be adapted to significant changes in the financial mechanisms and climate. – Benjamin Graham
What appeared to be a week of modest losses for the major stock averages turned into a rout on Friday after Federal Reserve Chairman Jerome Powell made hawkish comments at the Fed’s symposium at Jackson Hole. The S&P 500 Index and the Nasdaq Composite Index both plunged over 3% and ended the week with losses of more than 4% as Powell reiterated in his short speech that the Fed was determined to bring inflation under control and warned that its restrictive policies could be in place for some time. While the market was hoping that the Fed would pivot to an easier monetary policy after the improved July inflation data, Powell cautioned against easing monetary policy prematurely. He warned that there may be “some pain” ahead as interest rates move higher and said that the Fed will continue to hike rates until its 2% inflation target is reached. In his view, the longer high inflation continues, the greater is the likelihood that inflation expectations will increase. Also weighing on the stock market last week were weaker than expected earnings from several retail companies and both Nordstrom and Macy’s slashed their earnings forecasts for the balance of the year. Housing data also continued to be weak as July new home sales fell nearly 13% due to rising mortgage rates and higher home prices, leading many economists to conclude that housing is now in a recession. The National Association of Home Builders (NAHB) sentiment index in August also fell below 50 for the first time since May 2020. Home sales are likely to continue to slow and residential investment could negatively impact economic growth in the third quarter. Unfortunately, the stock market’s worst month for performance – September – is fast-approaching and stocks are likely to remain volatile as investor sentiment oscillates between hope for a soft economic landing and fears of a hard landing or a recession.
Durable goods orders for July were flat and less than expected while core capital goods, a proxy for business equipment investment, rose modestly. Labor and materials shortages continue to pose a challenge for companies as the fallout from the Russian invasion of Ukraine and periodic lockdowns in China have disrupted global supply chains. The second estimate of 2nd quarter GDP showed a decline of 0.6% compared to a decline of 0.9% in the first estimate. The July personal consumption expenditures (PCE) index, the Fed’s preferred measure of inflation, was slightly better than expected while the core PCE index that excludes food and energy prices rose 4.6% year over year, also lower than forecast. Weekly jobless claims were 243,000, down 2,000 from the prior week and lower than estimates of 255,000. The final August reading of the University of Michigan consumer sentiment index was much better than expected.
For the week, the Dow Jones Industrial Average lost 4.2% to close at 32,283 while the S&P 500 Index dropped 4.0% to close at 4,057. The Nasdaq Composite Index plunged 4.4% to close at 12,141.
The employment report for August is expected to show that about 290,000 new jobs were created and that the unemployment rate remains unchanged at 3.5%. ADP also releases its National Employment Report, which is forecast to show that 250,000 private payrolls were added. Both July construction spending and factory orders are expected to increase slightly and the August consumer confidence index is also expected to be higher than in July.
The most notable companies scheduled to report second quarter earnings this week are Crowdstrike Holdings, HP Inc., Hewlett Packard Enterprise, Ciena, Broadcom, Best Buy, Lululemon Athletica, Brown-Forman, Campbell Soup, Hormel Foods and Bank of Montreal.
Less than 10 minutes was all it took on Friday for Federal Reserve Chairman Jerome Powell to put investors on notice that the Fed is serious about bringing down inflation. Tighter monetary policy in the form of higher interest rates will likely mean continued volatility in the stock market and more anxiety for investors. With this forecast in mind, client portfolios should be positioned to include an overweighting of value stocks or funds over growth stocks. Value stocks typically are characterized by above average dividend yields and below market price earnings ratios that can trade for less than the underlying assets are worth. These companies are considered undervalued by investors and are perceived as relative bargains. Growth stocks, on the other hand, trade at much higher multiples to their projected earnings and usually pay little or no dividends. Technology stocks fall into this category and are especially vulnerable in a rising interest rate environment as the future value of their earnings stream is worth less. As far as fixed income investments are concerned, the duration of a client’s bond portfolio should also be shortened considerably to minimize the potential for losses. Duration measures a bond’s sensitivity to interest rate changes and is expressed in years. It considers such factors as a bond’s coupon rate, its time to maturity and the yield paid on the bond until it matures. Market interest rates and bond prices move in opposite directions i.e., higher interest rates cause bond values to fall. The longer the duration of a bond, the more sensitive it will be to higher interest rates and the more its price will decline. For this reason, it makes sense to shorten the average maturity or duration of a fixed income portfolio by including ultra-short or short-term bonds or bond funds to preserve the principal value. Since no one can predict where inflation, interest rates or the stock market are headed, it’s even more important to have a well-diversified portfolio based on one’s goals, risk tolerance and time horizon.