S&P 500 climbs 2.4% as investors downplay geopolitical risks

The stock market is the story of cycles and of the human behavior that is responsible for overreactions in both directions. – Seth Klarman

Stocks finally woke up from their listless and sideways trading recently and rewarded investors with strong gains last week. In what could be described as a delayed reaction to one of the best quarterly earnings seasons in recent memory, all three of the major stock averages rose at least 2% last week, with the technology-heavy Nasdaq Composite Index turning in the best performance with a gain of 2.7% and the Dow Jones Industrial Average posting its 7^th straight positive daily close. Companies have recorded earnings growth of over 20% in the first quarter, much better than expected and the best quarterly showing in seven years. Over three quarters of the S&P 500 companies that have announced their profit reports have beaten analysts’ estimates and revenue growth has also been strong. Concerns about trade tensions between the U.S. and China and the effects of the U.S. withdrawal from Iran nuclear deal took a back seat to what really drives stock prices – earnings. One immediate effect of pulling out of the Iran deal and reimposing sanctions on that country was a surge in oil prices to over $70 a barrel. Rising demand and tighter supply were already driving the price of oil higher, but the announcement only solidified the move. As a result, stocks in the energy sector led the charge with a weekly gain of nearly 4%. While a sudden increase in the price of oil may be seen as inflationary, inflation data released last week painted a much different picture. Both the producer price index (PPI) and the consumer price index (CPI) in April were relatively benign and less than forecast, suggesting that economic growth was not accelerating too fast. For investors, this meant that the Federal Reserve might not be as aggressive in raising interest rates, a potential headwind for stocks. From a technical standpoint, investors also felt emboldened to bid stock prices higher as the S&P 500 Index has traded down to its 200-day moving average three times this year and failed each time to trade below that level. If stocks can bend but not break, investors may take this as a signal that the market can only go higher.

Last Week

As mentioned above, the April producer price index (PPI) was much less than expected and only increased slightly while the consumer price index (CPI) also was less than forecast. In the 12 months through April, the core CPI, which excludes food and energy, has increased 2%, easing concerns that the Federal Reserve will tighten monetary policy at a faster pace. The preliminary University of Michigan consumer sentiment index in May continued to remain at a high level as consumers remain upbeat on future economic prospects.

For the week, the Dow Jones Industrial Average rose 2.3% to close at 24,831 while the S&P 500 Index gained 2.4% to close at 2,727. The Nasdaq Composite Index jumped 2.7% to close at 7,402.

This Week

Retail sales for April are expected to post another solid increase after registering a strong reading in March as consumer spending remains healthy. Both April leading economic indicators and industrial production are forecast to increase moderately and exceed levels reported in March.

Retailers will dominate this week’s earnings agenda as Dick’s Sporting Goods, Home Depot, Macy’s, Wal Mart, Nordstrom and JC Penney are scheduled to report. Other notable companies on the list include Cisco Systems, Applied Materials and Deere & Co.

Portfolio Strategy

One of the reasons for the stock market’s lackluster performance prior to last week has been the fear of higher interest rates caused by either stronger than expected economic growth or higher than anticipated inflation. While the inflation data released last week helped alleviate those fears, wage growth represents the biggest component of inflation and could accelerate if the labor market remains strong. Interest rates have risen in anticipation of faster economic growth and higher inflation that typically comes with a stronger economy. The yield on the 10-year Treasury has breached the 3.0% level and the yield on the 2-year Treasury has increased to 2.53% as the Federal Reserve has raised short-term rates and is on track to raise them two more times this year. The difference between the yield on the 10-year Treasury and the 2-year Treasury is now only 44 basis points. (A basis point is one hundredth of a percentage point). Or to put it another way, the 2-year Treasury yield is about 85% of the 10-year Treasury yield. With the rise in short-term interest rates, it doesn’t make sense to extend maturities too far to pick up a little incremental yield. While new bond issues will have higher yields, existing bonds with longer maturities have suffered the biggest losses. (Bond prices and yields move in opposite directions). This year, as the 10-year Treasury yield has risen to 2.97% from 2.41%, long-term bond funds have been the worst performers with losses of 5% to 6%. They are generally too volatile and risky to provide the ballast that investors need from their bond portfolios. For this reason, investors should structure their bond holdings so their overall average maturity is in the short-to- intermediate-term range, preferably less than five years in order to mitigate any losses from rising interest rates.