Stocks rise despite geopolitical tensions

Risk comes from not knowing what you are doing. – Warren Buffett

Despite ongoing tensions in the Middle East, Iraq and Ukraine, the stock market closed higher last week on stronger than expected second quarter corporate earnings. The yield on the 10-year Treasury note even fell to 2.3% before ending the week at 2.4% as investors sought a safe haven in the form of U.S. government debt. Geopolitical risks around the world continue to weigh on investor sentiment and the U.S. offers refuge from the worrisome and unpredictable events occurring in other countries. Although both stocks and bonds appear fully valued by most valuation measures, investors view the U.S. as the safest port in the storm. Economic data released last week was inconclusive as retail sales were weaker than expected while industrial production exceeded expectations. News from Europe was generally disappointing as some euro-zone economies weakened during the second quarter and Japan’s economy actually contracted. The one bright spot amid all of the geopolitical risks and lackluster economic data has been earnings as corporations have surprised on both the top line and the bottom line. Of those companies that have reported second quarter earnings, over 60% of them have beaten revenue estimates while almost 60% have exceeded earnings expectations. Earnings per share data have also been considerably higher than results from last year. Earnings are the most important determinant of stock price movements and as long as central banks worldwide remain mostly accommodative and global conflicts remain contained and isolated, it is difficult to bet against the stock market. 

Last Week

As alluded to above, retail sales in July rose only 0.1%, well below expectations of an increase of 0.4%. Wal-Mart Stores, the world’s largest retailer, was emblematic of sluggish retail sales as it lowered its earnings guidance for the year. Customer store traffic has declined for the seventh consecutive quarter as the retail giant struggles to improve sales.

Gross domestic product in the euro-zone was flat in the second quarter after registering only a 0.2% increase in the first quarter. The euro-zone’s largest economy, Germany, contracted in the second quarter while Italy’s fell slightly and GDP in France was unchanged. The worst measure of total output was reported by Japan as its GDP contracted by 6.8%. While central banks in Europe and Japan remain very accommodative, it’s entirely possible that further monetary easing measures may be taken to spur economic growth.

For the week, the Dow Jones Industrial Average rose 0.7% to close at 16,662 while the S&P 500 Index gained 1.2% to close at 1,955. The Nasdaq Composite Index jumped 2.2% to close at 4,464.

This Week

The Federal Open Market Committee (FOMC) releases minutes from its July meeting and it will be interesting to see if there are any clues as to the timing of the Fed’s much-anticipated interest rate hikes. Similarly, Fed Chair Janet Yellen will be the featured speaker at the Jackson Hole Fed Conference and any comments that she makes with regard to the timing and pace of possible Fed tightening will be closely watched. Most pundits expect the Fed to raise interest rates no later than mid-2015.

On the economic calendar, the consumer price index (CPI) is expected to increase only 0.1% as inflation remains under control. Leading economic indicators should rise 0.5% for July, suggesting that economic growth in the second half of the year should accelerate. July existing home sales are expected to slip from the previous month but should remain healthy.

Earnings reports will be dominated by retailers this week as Home Depot, Lowe’s Co., Staples, PETsMART, Target and TJX Co. are among those companies due to report. Other notable companies on the calendar are Hewlett-Packard, J.M. Smucker and Medtronic.

Portfolio Strategy

While there are still near-term geopolitical risks that will make investors hesitant about owning stocks, these risks should eventually disappear and allow the focus to be on fundamentals, which, for the most part, continue to be positive. An easing of tensions between Ukraine and Russia would help the European recovery and provide a boost for European stocks, which have been under pressure lately. After posting strong second quarter GDP growth, the U.S. economy seems poised to expand more rapidly and provide support for the stock market. To be sure, stocks are not cheap, but they are not expensive either, relative to other alternatives such as bonds and money market funds. Earnings have been much better than expected for the second quarter and S&P 500 earnings could be $120 this year, producing a market multiple of 16 times earnings based on Friday’s close of 1,955. With accelerating economic growth, low inflation and equally low interest rates and an accommodative Federal Reserve, all of the ingredients are in place for expansion of the price earnings ratio and higher stock prices. While a correction could certainly occur at any time, buying stocks on weakness should prove to be a winning long-term strategy as it has proved to be in the past.