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Strong stock market rally fades, but stocks still positive for the week

Your success in investing will depend in part on your character and guts, and in part on your ability to realize at the height of ebullience and the depth of despair alike that this too shall pass. – John Bogle 

After the S&P 500 Index fell more than 9% in September and over 5% in the third quarter, investors were happy to turn the calendar to October and bid goodbye to a month that historically has been the worst in terms of performance. On Monday and Tuesday, the S&P 500 Index posted its biggest two-day rally since March 2020, rallying nearly 6% as the yield on the 10-year Treasury dropped and the U.S. dollar also declined. Unfortunately, the huge rally in stocks fizzled out and it was downhill the rest of the week as the benchmark index wound up with a gain of only 1.5% for the week as worries resurfaced about additional monetary policy tightening by the Federal Reserve. Weaker than expected manufacturing data and a sharp drop in job openings early in the week were viewed by investors as good news and a sign that the economy was cooling and inflation was falling. Stocks soared on the news as it meant that the Fed might be less aggressive in hiking interest rates. But that hope began to fade on Wednesday when the Organization of Petroleum Exporting Countries (OPEC) agreed to cut oil production by two million barrels a day, raising fears that oil prices would be headed higher. Investors received more bad news on Friday when the September employment report showed that 263,000 new jobs had been created and that the unemployment rate fell to 3.5% from 3.7%. While the jobs total was less than forecast and the lowest monthly increase in jobs since April 2021, the decline in the unemployment rate all but ensured another 75-basis point (a basis point is one hundredth of one percent) rate hike by the Fed in November. Average hourly earnings also rose 5% from a year ago, which was slightly below estimates. The stock market has been following the bond market recently and the increase in the 2-year Treasury yield to 4.3% after the jobs data was released caused stocks to sell-off. (Bond prices and yields move in opposite directions). West Texas Intermediate crude oil also hit $90 a barrel after the OPEC announcement, making the path to a soft landing more challenging for the Federal Reserve.

Last Week

Other jobs-related data was mixed as ADP reported that 208,000 private sector jobs were added in September, more than the estimate of 200,000, but weekly jobless claims totaled 219,000, up 29,000 from the week prior and higher than expected. The September ISM manufacturing and non-manufacturing or services sector Purchasing Managers’ Indices (PMI) both edged lower but were still in expansion territory, although manufacturing was at the lowest level since the pandemic recovery began. Construction spending in August fell by the most in over a year with a sharp decline in single-family homebuilding as mortgage rates climbed.

For the week, the Dow Jones Industrial Average rose 2.0% to close at 29,296 while the S&P 500 Index increased 1.5% to close at 3,639. The Nasdaq Composite Index added 0.7% to close at 10,652.

This Week

The September consumer price index (CPI) is expected to increase 8.1% year-over-year, less than in August, while the producer price index (PPI) is forecast to increase 8.4% year-over-year, also less than in the previous month. September retail sales are expected to increase modestly as consumer spending has been a pleasant surprise despite higher inflation, helped by a strong job market and excess savings. The preliminary October University of Michigan consumer sentiment index is forecast to be slightly less than in September.

The third quarter earnings season begins this week and the big banks and financial companies will dominate the agenda. Among the most notable of these are JP Morgan Chase, Citigroup, Wells Fargo, Morgan Stanley, Blackrock, PNC Financial Services and U.S. Bancorp. Other prominent companies scheduled to report include PepsiCo, Walgreens Boots Alliance, UnitedHealth Group and Delta Air Lines.

Portfolio Strategy

Third quarter earnings season begins this week and the big money center banks and other financial companies will kick off the proceedings. So far this year, banks as a group have not performed well, posting double-digit losses, but outperforming the S&P 500 Index, which is down nearly 24%. The outlook for the banks was favorable at the beginning of the year as loan growth was expected to increase and higher interest rates were expected to increase banks’ net interest margins. The Federal Reserve has raised interest rates five times this year from near-zero to 3.25% with more rate hikes on the way. Unfortunately, higher interest rates aimed at reducing inflation also can also tip the economy into a recession, causing bank customers to borrow less and making it more difficult for them to pay back existing loans. Unlike the financial crisis that occurred in 2008 and 2009, though, banks are much better capitalized now with stronger balance sheets as they are subject every year to the Federal Reserves’ stress tests. For the most part, bank stocks are cheap and currently trade at historically low levels relative to their book value and net revenue. Fears of a recession have been the primary reason behind the banks poor performance this year and expectations heading into this quarter’s earnings season are rather low. With the bar set relatively low, bank earnings could surprise on the upside as net interest income should be strong due to higher interest rates and loan growth should still be positive, albeit slower than before. Bank earnings should also benefit from increased trading activity in the third quarter and nearly all the banks offer attractive dividend yields, which lends support to their stock price.