Dow closes above 26,000 as financials post strong quarterly earnings

Investors should always keep in mind that the most important metric is not the returns achieved but the returns weighed against the risks incurred. Ultimately, nothing should be more important to investors than the ability to sleep soundly at night. – Seth Klarman

Stocks continued to defy the laws of gravity as all three major averages posted gains again last week and, in the process, closed at all-time highs. The Dow Jones Industrial Average, S&P 500 Index and Nasdaq Composite Index each rose about 1%, with the Dow breaking through the 26,000 level for the first time ever on Tuesday and actually closing above this level the next day. The Dow first traded above 25,000 on January 4^th, making this the fastest 1,000 point move in history, just 12 calendar days. The stock market’s strength could be attributed to another week of solid quarterly earnings reports, especially from companies in the financial sector. Citigroup, Bank of America, Morgan Stanley, Goldman Sachs and American Express all managed to beat analysts’ earnings estimates, continuing the trend from the first week of earnings season. There were other positive corporate news items as well. For the first time in 5 years, IBM reported an increase in quarterly revenue and, in doing so, also beat earnings expectations. Apple  Computer announced plans to repatriate billions in overseas cash and said it would contribute $350 billion to the U.S. economy over the next 5 years and create 20,000 new jobs. Investors were optimistic that other U.S. corporations would follow suit and bring billions of dollars held overseas back home. This potential windfall not only could be used for business investment and capital spending to fuel future growth, but it could also be used for increased dividends, stock buybacks and mergers and acquisitions. Prospects for accelerating economic growth have a downside, though, and that was evident last week as the yield on the 10-year Treasury rose to 2.64%, the highest level since July 2014. Considering that the 10-year Treasury yield was 2.41% to start the year, this sudden rise bears watching and could have an effect on stocks if the yield rises further.

Last Week

U.S. housing starts fell more than expected in December and recorded the biggest drop in over a year. This weakness is likely to be temporary, though, as the strong labor market should support demand for housing. Although homebuilder confidence declined from an 18-year high, it should still remain elevated. December industrial production increased for the 4^th straight month and was better than expected. Weekly jobless claims fell 41,000 to 220,000, the lowest level in 45 years and yet another sign that the labor market remains strong.

The Federal Reserve’s Beige Book said that the U.S. economy and inflation were growing at a modest-to-moderate pace, but despite weak inflation, the Fed still plans to raise interest rates three times this year as the economy remains at or near full employment. The Senate failed to pass a funding bill and the government shut down officially on Saturday.

For the week, the Dow Jones Industrial Average rose 1% to close at 26,071 while the S&P 500 Index gained 0.9% to close at 2,810. The Nasdaq Composite Index added 1% to close at 7,336.

This Week

Both December existing and new home sales are expected to decline modestly from November levels but still be representative of a healthy housing market. December leading economic indicators and durable goods orders are forecast to post moderate gains while the preliminary GDP number for the fourth quarter is expected to be 3%.

This week promises to be a busy one for quarterly earnings reports and will include a wide range of companies. The most notable of these include Procter & Gamble, Starbucks, Verizon, Intel, Texas Instruments, Johnson & Johnson, Abbott Labs, General Electric, Ford Motor, Honeywell, Caterpillar, 3M, General Dynamics and Union Pacific.

Portfolio Strategy

While the House of Representatives voted on Friday to fund the government, the Senate was not able to muster the 60 required votes and, as a result, a government shutdown began on Saturday. Political uncertainty is not uncommon as evidenced by the ongoing tensions between the U.S. and North Korea and the current investigation into alleged Russian meddling in the 2016 presidential election. Rarely do events such as these have any lasting impact on stocks. Even though the stock market may appear vulnerable with the major averages at all-time highs and equity valuations stretched, investors should remain calm and not worry too much. A look back at past government shutdowns and their effect on the stock market shows that there has been only modest weakness in stocks and no significant market sell-offs. During periods when the government has been shut down since 1976, the S&P 500 Index has lost an average of less than 1%. More recently, stocks have weathered the uncertainty caused by the last three shutdowns well, posting gains during these closures. Government shutdowns may make good political theater and grab headlines in the newspapers, but investors should remain focused on the fundamentals, such as improving economic data, growing corporate profits and the benefits of corporate tax reform and tax cuts. This is what really matters in determining the direction of stock prices.