Stocks near record highs as Fed rate hike likely delayed

The individual investor should act consistently as an investor and not as a speculator. – Benjamin Graham

For the second consecutive week, the major stock averages closed higher with the Dow Jones Industrial Average once again above the 18,000 level and the S&P 500 Index just barely above 2,100. Both benchmarks were up almost 2% for the week and are trading near their all-time highs. What had looked like a negative for stocks actually turned into a positive as the weak March employment report released on Good Friday meant that the Federal Reserve would most likely delay any increase in interest rates. With stock index futures pointing to a much lower open on Monday, stocks traded down about 1% before reversing course and ending the day with a sizable gain. Bad news was perceived as good news and the stock market never looked back the remainder of the week. Minutes from the March Federal Reserve meeting only seemed to add fuel to the fire as comments revealed much disagreement among Fed officials but an overall dovish tone. The exact timing of an eventual rate hike was debated back and forth, with some in favor of June, others in September and still others who felt that an interest rate increase was not warranted until 2016. Although the weekly jobless claims rose slightly, they still remain low as the more reliable four-week average fell to 282,000, indicating a strong labor market with fewer layoffs. Much lower interest rates in the rest of the world are also providing little incentive for the Fed to raise rates. A current yield of 0.15% on the 10-year German Bund is but one example of these paltry yields and why U.S. government bonds continue to attract so much buying interest and act to keep Treasury yields low. The next major hurdle for the stock market will be first quarter corporate earnings, which begin in earnest this week after traditional front-runner Alcoa began the parade last week with better than expected earnings.

Last Week

Although there was very little in the way of economic news last week, the few reports that were released were positive. The Institute for Supply Management’s (ISM) non-manufacturing or service sector index was slightly better than expected with the health care and retail sectors expanding the most. Consumer borrowing also increased by a healthy amount as increases in automobile and student loans offset a decline in credit card debt. U.S. import prices fell slightly due primarily to low oil prices and the strong dollar, which makes foreign goods cheaper.

General Electric announced a major restructuring that entails selling its GE Capital finance unit and real estate assets in order to simplify its business by focusing on its core industrial businesses. The company also announced plans to buy back up to $50 billion of its common stock. Shares of General Electric closed up 8% on the news.

For the week, the Dow Jones Industrial Average gained 1.7% to close at 18,057 while the S&P 500 Index also added 1.7% to close at 2,102. The Nasdaq Composite Index jumped 2.2% to close at 4,995.

This Week

This promises to be a busy week on the economic calendar. The March producer price index (PPI) and consumer price index (CPI) will be released and both are expected to show only a modest increase, indicating that inflation is benign and remains well under control. March retail sales are forecast to rebound from a weak February and rise 1%. Housing starts in March are also expected to bounce back from February, a month in which home building was adversely affected by the cold and snowy winter.

Earnings season will get into full swing this week and will be dominated by banks and financial companies. Among those due to report are JP Morgan Chase, Wells Fargo, Bank of America, CitiGroup, U.S. Bancorp, Goldman Sachs and American Express. Other heavyweights scheduled to report first quarter earnings include Intel, Kinder Morgan, Schlumberger, Johnson & Johnson and General Electric.

Portfolio Strategy

When the year began, expectations among analysts were for earnings to increase about 4% in the first quarter and about 5% in the second quarter. A strong dollar, falling oil prices and weak global economies have forced analysts to slash those earnings forecasts considerably. First quarter earnings are now expected to drop about 4% while second quarter earnings are expected to tumble about 2%. Responsible for most of this downward revision has been the sharp drop in oil prices as companies in the energy sector are forecast to report a 60% decline in profits. A strong dollar also could take a bite out of the quarterly profits of multinational companies that generate the bulk of their revenues overseas. With the S&P 500 Index trading at a price earnings ratio above its historical norm, it’s understandable that investors would be anxious about the upcoming earnings season. The absence of organic earnings growth could lead companies to adopt other measures to boost their bottom lines, such as stock buybacks or merger and acquisition activity. While these methods are not preferred and border on financial engineering, they might be enough to appease investors until the economy rebounds in the second half of the year and lays the groundwork for stronger profit growth. This earnings season could determine whether or not the anticipated decline in first quarter earnings is already priced into the markets. If it is, then the key to further gains in the stock market will be on company guidance of those earnings for the balance of the year.