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Strong jobs report sinks stocks on rate hike fears

Only buy something that you’d be perfectly happy to hold if the market shut down for 10 years. – Warren Buffett

Good news for the economy proved to be bad news for the stock market on Friday as the stronger than expected jobs report caused stocks to plunge. All of the major stock averages closed lower in a week that saw the S&P 500 Index and the Dow Jones Industrial Average close at an all-time high on Monday and the Nasdaq close above 5,000 for the first time in 15 years. Most of the weekly losses happened on Friday as the employment report showed that the U.S. economy created 295,000 jobs and that the unemployment rate dipped to 5.5%, the lowest level in almost seven years. Most economists had forecast the creation of about 240,000 new jobs. It marked the twelfth straight month that the economy had created at least 200,000 jobs and the much stronger-than-expected number occurred despite a brutal winter across most of the country. While more people stopped looking for work and hourly wages only rose three cents or 0.1%, the employment report was powerful enough to convince investors that the Federal Reserve may now raise interest rates sooner rather than later, perhaps as early as June. Fear of rising rates sent stock investors scurrying for the exits and caused the bond market to sell-off, too, as the yield on the 10-year Treasury rose to 2.24%. To be sure, the news on the job front is definitely positive for the economy and stocks in the long run, but caught investors by surprise as low interest rates have provided the catalyst for much of the stock markets’ gains.  The bull market in stocks marks its sixth year anniversary on March 9th and it is understandable that investors might be a little trigger-happy at the possibility of it coming to an end. The employment report, however, is but one of many pieces of economic data that are due to be released over subsequent months and they all promise to paint a different picture of the strength or weakness of the economy.

Last Week

Prior to the release of the jobs report on Friday, the week was uneventful despite a plethora of economic data. The ISM index of factory activity and the manufacturing purchasing managers’ index in January were both solidly above fifty, a reading that indicates continued expansion. The ISM non-manufacturing index was also well above this threshold and better than estimates. While personal income rose modestly, personal spending fell slightly and U.S. automobile sales were weaker than expected due to the harsh winter weather. Factory orders also declined slightly in January due to weak demand in Europe and Asia, a strong dollar and lower oil prices. The Federal Reserve’s beige book gave an upbeat assessment of almost all sectors of the economy in each of its districts.

In overseas news, China cut its benchmark interest rates by 25 basis points as a way to help boost economic growth. The European Central Bank (ECB) raised its growth estimate for 2015 to 1.5% from 1.0% and will begin its $66 million a month bond-buying program on Monday. Back in the U.S., it was announced that Apple would replace AT&T in the Dow Jones Industrial Average on March 18th.

For the week, the Dow Jones Industrial Average sank 1.5% to close at 17,856 while the S&P 500 Index lost 1.6% to close at 2,071. The Nasdaq Composite Index dropped 0.7% to close at 4,927.

This Week

There are only a few significant economic reports on tap for this week. Retail sales for February are forecast to increase 0.4% after declining by the same amount in January. The producer price index (PPI) is expected to show a modest gain and confirm that inflation remains under control.

The Federal Reserve will announce the results of its stress tests on banks to determine whether they can pay dividends and buy back stock. China will be watched closely as economic data on consumer and producer prices, industrial production and retail sales are reported.

Retailers will be in the spotlight again this week as Barnes & Noble, Williams & Sonoma, Men’s Wearhouse, Dollar General, Stein Mart, Urban Outfitters and Aeropostale are scheduled to report earnings.

Portfolio Strategy

In addition to the losses suffered in the stock market last week, the bond market also declined after the strong employment report was released. The yield on the 10-year Treasury has risen to about 2.25% from just under 2.00% a few weeks ago. As bond investors know all too well, as interest rates rise, the price of bonds and bond funds falls. While the temptation might be to dump your bonds at the prospect of rising yields, that could actually do more harm than good to your bond portfolio. Most economists had forecast that interest rates would rise the last few years only to find out that just the opposite happened. It’s nearly impossible to accurately predict which direction interest rates are headed and foolish to even try. The best strategy is to shorten the duration of the bond portfolio somewhat in order that the overall average maturity is short-to-intermediate term in length. For an individual bond portfolio, a simple ladder of maturities or a barbell strategy that invests in both short- and long-term bonds would be a prudent approach. In a rising interest rate environment, bonds that mature in an individual bond ladder or in bond fund are reinvested at higher rates, thereby reducing the reinvestment risk and maintaining the overall yield and income flow. More importantly, the bond portion of the portfolio is designed to protect against the volatility of stocks and other more risky asset classes and provide safety and a reliable source of income. With the European Central Bank set to begin its massive bond-buying program this week, yields there should fall even further and make yields on U.S. securities downright attractive by comparison. This discrepancy should help keep a lid on interest rates here as demand for our bonds should increase.