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Stock market averages mixed on earnings concerns

Stock price movements actually begin to reflect new developments before it is generally recognized that they have taken place. – Arthur Zeikel, former Chairman of Merrill Lynch Asset Management and author of several investment publications

While second quarter earnings have generally been better than expected, it was two disappointing reports on Friday that took the wind out of the stock markets’ sails and resulted in the Dow closing lower for the week. Visa, one of the world’s largest credit card companies, issued a much weaker than expected revenue outlook while reported a huge loss due to an increase in capital spending. About half of the Dow’s loss was attributable to the slump in Visa shares. Prior to their announcements, the stock market was headed for modest weekly gains on strong corporate earnings results. In fact, with about half of the companies in the S&P 500 reporting earnings so far, over 75% of them have beaten analyst estimates while over 65% have also eclipsed revenue targets. Average earnings growth has also exceeded expectations by a wide margin. In addition to the mostly positive tone to the earnings season, economic data released last week also painted a pretty picture. The most surprising piece of data was the drop of 19,000 in U.S. jobless claims to 284,000, the lowest level since February 2006. Far fewer layoffs should portend increased job growth, boosting employees’ paychecks and leading to greater confidence and more spending by consumers. With such a preponderance of good news, it’s no wonder that the S&P 500 Index reached a record level for the 26th time this year. Friday’s stock market reaction to two weaker than expected earnings reports was probably more a function of good, old-fashioned profit-taking than anything else. With the market hovering near all-time highs, it’s never a bad idea to take a few chips off the table.

Last Week

The news on the inflation front was positive as the core consumer price index (CPI) rose just 0.1% in June and has risen only 1.9% over the past twelve months. For the housing sector, the data was mixed as existing home sales jumped a better-than-expected 2.6% in June but sales of new homes dropped 8.1%. These numbers suggest that the housing market recovery continues to be inconsistent and raises concerns about the overall health of the sector. While durable goods orders for June were strong, the previous months’ orders were revised downward, basically offsetting one another.

China reported better than expected manufacturing data and eased some concerns that economic growth in the world’s second largest economy was slowing. The Shanghai Composite Index reacted positively to the news. Lately, emerging market stocks have been outperforming U.S. stocks as investors have sought out markets with more attractive valuations.

For the week, the Dow Jones Industrial Average slipped 0.8% to close at 16,960 while the S&P 500 Index shed just 0.01% to close at 1,978. The Nasdaq Composite Index added 0.4% to close at 4,449.

This Week

All eyes will be on the Federal Reserve this week as it releases its statement on the economy and the FOMC issues its monetary policy statement. No major changes are expected as the Fed will most certainly reduce its monthly bond-buying program by another $10 billion and reiterate that any increase in interest rates will be dependent on economic data. The central bank asset purchases are scheduled to end in October while most observers believe that rates will begin to rise in 2015.

The initial reading on second quarter gross domestic product (GDP) should show an increase of almost 3%, offsetting almost one-for-one the first quarter contraction of 2.9%. The employment data for July should continue to confirm an improving labor market as the number of jobs created is expected to be about 225,000 while the unemployment rate should remain at 6.1%.

Earnings reports will continue in abundance this week with companies such as Merck, Pfizer and Amgen in the health care sector, Chevron and Exxon Mobil in the energy sector, Procter & Gamble and Colgate-Palmolive in the consumer non-durables sector, American Express in the finance sector and Automatic Data Processing in the technology sector.

Portfolio Strategy

Despite mostly positive earnings reports and economic data last week, the abrupt sell-off on Friday should give investors pause as to the sustainability of the stock market rally. With the market perched near all-time highs, it’s only natural to question the market’s strength and ask oneself what, if anything, could happen to derail stocks. With the end of quantitative easing only months away, the financial markets could overreact to the end of the bond-buying program and send stocks lower. Stronger than expected economic growth could also lead to higher inflation, causing the Fed to tighten sooner than anticipated. On the other hand, wage growth has only increased about 2.3% over the last year, barely keeping pace with the rate of inflation. Such an environment is not a recipe for increased consumer spending, which accounts for about two thirds of GDP.  A sluggish economy could weaken stock prices and investor optimism. While corporate earnings have generally been good the past couple of years, companies have also been buying back their own stock, which boosts earnings per share by reducing the number of shares outstanding. Corporations could stop borrowing money to fund these stock buybacks, hurting earnings per share. Overseas, the European Central Bank faces some of the same problems as the Federal Reserve as the sustainability of Europe’s economic recovery has been called into question and deflation remains a concern. Rising geopolitical tensions in many parts of the world are an ever-present danger and pose another risk for stocks. Although current corporate earnings and economic data paint a rosy picture for stocks and the U.S. economy, there are a number of different scenarios that could develop to alter this sanguine outlook.