Stocks rally after Bank of Japan cuts interest rates

While it might seem that anyone can be a value investor, the essential characteristics of this type of investor – patience, discipline and risk-aversion – may well be genetically determined. – Seth Klarman, American billionaire who founded one of the world’s largest hedge funds

After languishing in the red for most of the week, the stock market soared on Friday after the Bank of Japan surprised investors with an announcement that its benchmark interest rates would be pegged below zero. The price of oil also rebounded last week to close above $33 a barrel, easing concerns about the negative effects of low oil prices on the energy sector. The Japanese economy has been in the doldrums and the move by central bank officials to adopt negative interest rates may be a last ditch effort to reignite growth. Japan is not the only country whose economic growth is slowing. The European Central Bank (ECB) hinted just recently that additional stimulus measures were being considered to revive its moribund economy and boost inflation. In the U.S., even the Federal Reserve acknowledged in their statement last week that the economy had slowed and that inflation is likely to remain low in the near term. It also changed its view on consumer spending and business investment growth to “moderate” from “strong” in the December statement. The release of fourth quarter gross domestic product (GDP) on Friday confirmed this viewpoint as growth slowed to 0.7% and expanded at only a 2.5% rate for all of 2015. In fact, the last time that annual GDP growth exceeded 3% was way back in 2005. Weakness in consumer spending, manufacturing and energy as well as fewer exports and smaller increases in business inventory were primarily responsible for the anemic growth. Inflation as measured by the Fed’s preferred indicator, the personal consumption expenditure (PCE) index, also fell slightly and was well below the Fed’s target rate of 2%. Once again the rally in stocks on Friday was a case of bad news in the form of weak economic growth being perceived as good news by investors in the form of additional monetary easing by a global central bank; in this case, Japan. In light of the weak U.S. GDP data for the fourth quarter, it is also less likely that the Federal Reserve will continue with its initial plan to raise interest rates four times this year. Sooner or later, though, economic data will have to improve on a consistent basis for the stock market to move much higher.

Last Week

On the housing front, the S&P /Case-Shiller Home Price Index rose faster than expected in November, helped by low mortgage rates, lean inventories and an improving labor market. New home sales in December were also strong, rising nearly 11% in the month. Adding to the concern about weakening economic growth, U.S. durable goods orders fell 5.1% in December, much worse than expected. The biggest upside surprise was the Chicago purchasing managers index (PMI), which unexpectedly surged to nearly 56 in January, comfortably in expansion territory.

There were unsubstantiated reports last week that OPEC and non-OPEC countries might agree to a plan to reduce oil production by 5% for each country. These rumors helped contribute to the rise in crude oil prices for the second consecutive week.

For the week, the Dow Jones Industrial Average added 2.3% to close at 16,466 while the S&P 500 Index gained 1.8% to close at 1,940. The Nasdaq Composite Index rose 0.5% to close at 4,613.

This Week

The Institute for Supply Management (ISM) manufacturing index is expected to be at the break-even level for January, indicating neither expansion nor contraction. December factory orders are forecast to show a slight decline. The January employment report is due to be released on Friday and the expectation is for about 200,000 new jobs to be created with the unemployment rate remaining unchanged at 5%.

The 50^th Super Bowl will be played on Sunday between the Carolina Panthers of the National Football Conference (NFC) and the Denver Broncos of the American Football Conference (AFC). Investors should be rooting for the Carolina Panthers if for no other reason that the Dow Jones Industrial Average has performed considerably better in years when an NFC team wins than if an AFC team wins.

It will be another busy week for fourth quarter earnings reports as Alphabet (formerly Google), Automatic Data Processing, Pfizer, Merck, Exxon Mobil, ConocoPhillips, Occidental Petroleum, Dow Chemical, General Motors, UPS, MetLife and Philip Morris International are just a few of the more prominent companies scheduled to report.

Portfolio Strategy

Despite the stock market rally on Friday of last week, the S&P 500 Index finished the month of January with a loss of 5.1%. Although the stock market has experienced one of the worst starts to a year since 1950, there are reasons to be optimistic about stocks in 2016. The U.S. labor market continues to be strong with a low unemployment rate of 5% and 292,000 new jobs created as recently as December. Another 200,000 new jobs should be added in January. The housing sector also remains strong as home prices continue to rise and recent data on housing starts and new home sales confirm a healthy real estate market. Ultimately, low oil prices should prove to be a boon to the U.S. economy as they act like a tax cut for consumers, putting more money in their pockets and giving them additional discretionary income. While China’s economy has slowed, the effect on the U.S. economy should be minimal as our exports to China account for about 1% of our total GDP. Many stocks have already suffered declines of 20% from their 52-week highs and the S&P 500 Index now trades at about 16 times estimated earnings for 2016, a reasonable multiple considering that the 10-year Treasury now yields only 1.93%. The headwinds of a strong dollar on profits of multi-national companies that export to foreign markets should begin to abate as the year progresses. For the most part, fourth quarter earnings reports have been better than expected, although revenue growth has admittedly been a struggle for companies and guidance going forward has been cautious. Recent consumer sentiment data also points to consumers being as confident as ever, despite the correction in stocks. This optimism should bode well for an economy where almost 70% of economic growth is based on consumer spending.