Stocks surge on earnings optimism, dovish Fed minutes

If you are shopping for common stocks, choose them the way you would buy groceries, not the way you would buy perfume. – Benjamin Graham

Bullish sentiment returned to Wall Street last week as the S&P 500 Index jumped 3.3% on optimism that quarterly earnings will beat lowered expectations and that the Federal Reserve will maintain its near-zero interest rate policy. The release of minutes from the most recent Federal Open Market Committee (FOMC) meeting showed that Fed officials worried about the global economic slowdown but didn’t think it “materially altered” the outlook for the U.S. economy. They felt that it was prudent to wait because of risks to the outlook for economic growth and inflation. Just a few weeks ago, the stock market plunged using the same thought process when the Federal Reserve decided not to raise interest rates. Investors questioned whether or not slowing global economic would jeopardize corporate profits. Even former Federal Reserve Chairman Ben Bernanke remarked last week that he sees no reason why the Fed should rush to increase interest rates when inflation is still below its 2% target. Now investors believe that any Fed action on hiking interest rates is off the table for the rest of the year. Another contributing factor to the surge in stock prices last week was a weakening dollar, which boosts the bottom line of multi-national companies that export their products overseas. Rising commodity prices, including the price of oil, which climbed to nearly $50 a barrel, also propelled stocks higher as companies in the energy, resource and material sectors all benefited. The stock market’s direction now will come from third quarter corporate earnings as Alcoa unofficially began the earnings season last week by missing estimates on both the top and bottom line. Not only will earnings results be important, but also what companies say about their business and their earnings guidance going forward.

Last Week

Although the Institute for Supply Management (ISM) services sector index fell slightly in September, it remained comfortably above 50, a sign of continued robust expansion. The services sector accounts for 70% of U.S. gross domestic product (GDP). The U.S. trade deficit rose to $48.3 billion as a strong dollar contributed to falling exports that reached a three year low. Jobless claims fell 13,000 last week to 263,000, a near 42-year low, as companies are laying off fewer workers.

The International Monetary Fund (IMF) trimmed its forecast for global growth to 2.6% this year and 2.8% in 2016. Atlanta Fed President Dennis Lockhart said an interest rate hike is possible in October or December despite conflicting economic signals while the Chicago Fed’s Charles Evans said what really matters is the path of rate hikes and not the timing of an initial hike.

For the week, the Dow Jones Industrial Average rose 3.7% to close at 17,084 while the S&P 500 Index gained 3.3% to close at 2,014. The Nasdaq Composite Index added 2.6% to close at 4,830.

This Week

Stock markets in the U.S. are open on Columbus Day but banks and the bond market are closed. Both the September producer price index (PPI) and consumer price index (CPI) are expected to drop 0.2% as inflation continues to be benign. Retail sales for September are forecast to rise 0.3% on strong automobile sales but industrial production is expected to decline modestly.

The earnings calendar is full this week and banks and financial services companies will dominate. Among those scheduled to report will be JP Morgan Chase, Wells Fargo, Citigroup, Bank America, Goldman Sachs, SunTrust Banks and U.S. Bancorp. Other prominent companies due to report quarterly earnings include Intel, Johnson & Johnson, GE, Honeywell, CSX and Schlumberger.

Portfolio Strategy

As we head into the third quarter earnings season, consensus estimates call for a 4% year-over-year decline in S&P 500 earnings as weakness in the energy sector and a strong dollar provide major headwinds for companies. If the effects from these two factors are removed from the calculation, earnings are actually expected to rise about 2% or 3%. Concerns about slowing global economic growth, particularly in China, as well as uncertainty over a Federal Reserve interest rate hike, have caused analysts to lower their corporate earnings estimates. As a result of these downward revisions, it should be easier for companies to beat these lowered expectations. With the recent stock market correction fresh in their minds and investor bearishness on the rise, it’s possible that stocks could react positively to the earnings results, especially with the Federal Reserve on hold with regard to a rate hike. While there is evidence of slower growth in China, the effect on the profits of S&P 500 companies should be minimal as their exports to China account for less than 1% of our gross domestic product (GDP). Only modest earnings growth is forecast for both this quarter and the year, though, and it will be difficult for stocks under these circumstances to post mid-to-high single digit returns for 2015. With the S&P 500 Index currently down 2% from its 2014 year-end close, a more realistic and hopeful scenario would be for returns for the year in the low single digits.