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S&P 500 posts modest loss on weak economic data

Don’t look for the needle in the haystack. Just buy the haystack! – John Bogle, founder of the Vanguard Group, a $3 trillion mutual fund firm that popularized index investing

Lackluster U.S. economic data and heightened fears that an agreement between Greece and its creditors may not be reached led to modest losses for the major stock averages last week. There was no place to hide as all of the major sectors of the S&P 500 Index suffered losses. Although it was widely expected, the most alarming piece of economic data released last week was the revised first quarter GDP report that showed the economy actually contracted. Increased imports and a smaller inventory buildup were largely responsible for the shrinkage in growth. Corporate profits also fell about 6% in the first quarter in what has been the weakest U.S. economic recovery since the end of World War II. The recovery is now in its 7th year and while recent data suggest that the economy should improve, it is by no means certain.  Weaker than expected manufacturing data in Chicago and declining orders for U.S. durable goods cast doubt on the widely held belief that the economy will bounce back in the second quarter. With an unemployment rate of only 5.4%, a seven-year low, and the average jobless claims over the last month near a fifteen-year low, one would expect consumers to increase their spending. Since consumers account for about two-thirds of all economic activity, their spending behavior is vital to the expected economic recovery. Overseas, the uncertainty surrounding the ongoing Greek saga and the approaching debt repayment deadline also caused some nervousness among investors and weighed on sentiment. As reports on the talks seesawed from optimistic to pessimistic last week, investors were on edge about the possibility of Greece exiting from the euro zone and the consequences such an exit might have on the rest of Europe.

Last Week

The one bright spot last week in the economic reports was the housing data. U.S. new home sales and prices rose strongly in April, suggesting that the housing market recovery was gaining traction. Pending home sales in April also rose to the highest level in nine years. In addition to the good news on the housing front, business spending plans increased solidly for the second straight month. Non-defense capital goods orders increased 1% in April and the number for March was also revised higher. As alluded to above, the Chicago purchasing manager’s index (PMI) fell to 46 in May from a reading of 52 in April. A reading below 50 indicates contraction.

For the week, the Dow Jones Industrial Average dropped 1.2% to close at 18,010 while the S&P 500 Index declined 0.9% to close at 2,107. The Nasdaq Composite Index fell 0.4% to close at 5,070. The Dow Jones Transportation Index skidded 2.2%, a potentially troubling sign for stocks for those who believe in Dow Theory.

This Week

This week promises to be an important test for the market as there is a plethora of important news items and economic reports. The employment report for May is forecast to show an increase of 220,000 new jobs and the unemployment rate is expected to remain at 5.4%. Other economic data include April construction spending, which is expected to rebound strongly from the previous month, and April factory orders, which is expected to be flat. The ISM manufacturing report for May should remain above 50 and indicate that the manufacturing sector continues to expand.

The Federal Reserve’s beige book of regional economic data will be released mid-week while several Fed officials will speak about monetary policy. In overseas news, Greece must repay the International Monetary Fund (IMF) 1.5 billion euros by Friday and OPEC begins its summit meeting on Wednesday. The Bank of England also is scheduled to meet and no changes are expected in its monetary policy.

The earnings calendar is light this week with the most notable companies on the agenda being Medtronic, Dollar General, J.M. Smucker, Joy Global and Verifone Systems.

Portfolio Strategy

With the S&P 500 Index stuck in a trading range between 2,130 and 2,050 and long overdue for at least a 10% correction, it isn’t unreasonable to question the current valuation of the market. There are several valuation measures available to investors. Based on earnings estimates of $120 per share in 2015 for companies in the S&P 500 Index, the market currently trades at about 17.5 times those earnings, which is above its historical price earnings ratio of 14 or 15. While this valuation may seem high, it is not that expensive in the context of historically low interest rates. Another valuation measure is earnings yield, which is calculated by dividing the S&P 500 earnings by the price of the index. Even if S&P 500 earnings are flat this year, the earnings yield would be about 5.5%, which compares very favorably to the current 10-year U. S. Treasury yield of 2.2%. While the coupon rate on a 10-year note is fixed, earnings are likely to grow over time unless there is a recession, which is not in the forecast this year. Relative to the Treasury yield, the earnings yield looks very attractive. There also is a measure of valuation called the Rule of 20, which states that the price earnings ratio when added to the inflation rate should equal 20. If one uses an inflation rate of 1.8% (increase in core CPI over past 12 months), then the P/E ratio would be about 18, which is about where it is now based on trailing earnings. The market has not experienced a 10% correction in three years and it’s almost impossible to predict what may cause one in the near future. Based on these valuation metrics, though, the stock market is neither overvalued nor undervalued.