Stocks rise as Fed stands pat on interest rates

Nobody can predict interest rates, the future direction of the economy, or the stock market. Dismiss all such forecasts and concentrate on what is actually happening to the companies in which you’ve invested. – Peter Lynch

Despite hawkish comments from several Federal Reserve officials recently, Fed Chair Janet Yellen and the Federal Open Market Committee (FOMC) decided not to raise interest rates last week and the markets breathed a collective sigh of relief. The S&P 500 Index and the Nasdaq Composite both rose 1.2% as investors cheered the news and applauded comments by Janet Yellen. She expressed confidence in the economy but wants to see more progress in the labor market and more evidence of inflation. Because she expects both the jobs data and inflation data to increase, Yellen said that she expects one more interest rate hike this year, probably in December. On the same day as the FOMC announcement, the Bank of Japan (BOJ) said it would buy 10-year Japan government bonds to keep yields near zero percent and left its deposit rate at negative 0.1%. The BOJ also said that it was possible that interest rates could move even further into negative territory. While the stock market liked what the two major central banks had to say, many economists are becoming increasingly wary of their moves. They contend that they are running out of ammunition and that quantitative easing has lost its effectiveness. This assessment may be true, but as long as interest rates stay lower for longer, equities look more attractive by comparison and are not considered as overvalued, either. Compared to the yield on the 10-year Treasury of 1.60%, there are many stocks in defensive sectors such as utilities, telecom and consumer staples that offer dividend yields in excess of 3% and also have the potential for price appreciation longer-term. This relative attractiveness of equities relative to bonds may prove to be auspicious for stocks, especially as the stock market enters what is considered its seasonally best period for returns – October through December. Standing in the way, though, will be the third quarter earnings season in October and the U.S. presidential election in early November.

Last Week

Economic data released last week generally supported the Fed’s decision to leave interest rates unchanged last week. U.S. housing starts were worse than expected in August although building permits for single-family homes rebounded, suggesting that demand is still strong. This demand is being driven mostly by a strong labor market and modest wage growth. Manufacturing data was also weaker than expected.

After rising earlier in the week on a report by the Energy Information Administration (EIA) that crude oil inventories fell, the price of oil declined on Friday on reports that Saudi Arabia does not see an oil output agreement at Monday’s OPEC meeting.

For the week, the Dow Jones Industrial Average rose 0.8% to close at 18,261 while the S&P 500 Index gained 1.2% to close at 2,164. The Nasdaq Composite Index also added 1.2% to close at 5,339.

This Week

August durable goods orders are expected to fall slightly after posting a very strong month in July. August new home sales are also expected to decline from the previous month but still be indicative of an improving housing market. The third estimate of second quarter GDP is expected to be revised slightly higher to 1.2% from 1.1%. Finally, the September Chicago purchasing managers index (PMI) for manufacturing should edge higher and show a sector that is still expanding.

The first presidential debate between Democrat Hillary Clinton and Republican Donald Trump will take place on Monday night. A number of Fed presidents are also scheduled to speak this week and offer their views on the economy and monetary policy.

It will be another rather slow week for quarterly earnings reports as Nike Inc., PepsiCo, ConAgra Foods, Costco Wholesale, Accenture and McCormick & Co. are among the most notable companies due to report.

Portfolio Strategy

In addition to the relative attractiveness of stocks over bonds given the paltry yields that fixed income investments offer investors, another potential bullish underpinning for equities is cash levels. Recent surveys indicate that fund managers are holding above-average cash positions, generally in excess of 5.5%. Investment strategists usually consider any cash levels above 4.5% a signal for investors to buy stocks. Many fund managers have been holding excessive amounts of cash as protection against the Federal Reserve raising interest rates and concern over rising valuations in both the stock and bond markets. They have become worried about capital preservation and increased market volatility. But eventually this cash must find a home as money market funds effectively yield zero. When this money on the sidelines does find a home, it could provide the buying power to ignite a rally in stocks and drive bond prices even higher, thereby lowering interest rates even further. Although earnings are ultimately what drive stock prices higher, excess cash positions waiting to be put to work can also provide the fuel to lift prices.