Stocks decline on Portuguese bank fears

And finally, no matter how good the science gets, there are problems that inevitably depend on judgment, on art, on a feel for financial markets. – Martin Feldstein, American economist

The stock market succumbed to a fear of heights last week as investors took profits after a report surfaced that a relatively small bank in Portugal delayed one of its debt payments. Global markets were weak as investors became concerned that such problems would spread to other countries as well. These jitters stemmed primarily from fears about the fragility of Europe’s banking system and hopefully will prove to be an isolated incident. Small cap stocks, perceived as the most risky, suffered the worst losses as the Russell 2000 Index lost 4%. However, economic fundamentals still remain in tact in both the U.S. and Europe and investors were probably just looking for an excuse to sell with the Dow Jones Industrial Average trading above 17,000 and the S&P 500 Index within striking distance of 2,000, both psychologically significant levels. Second quarter corporate earnings season also began last week and while only a handful of companies reported, two of the most prominent, Alcoa and Wells Fargo, posted strong earnings. Both companies are good indicators for the health of the economy and these results bode well for the avalanche of profit reports due this week. With many so-called market experts expecting and even predicting a correction of as much as 10%, it will more likely come from a disappointing earnings season than of a Portuguese bank missing a bond payment.

Last Week

The labor market continued to improve as jobless claims fell to a nearly 7-year low with a drop of 11,000. In the minutes from the Federal Reserve policy meeting in June, a decision was made to end the bond-buying program in October if the economy doesn’t weaken. The Fed will make a $15 billion reduction in the asset purchase program at the October meeting and this will complete the tapering process. The Fed also intimated that interest rates would remain low for “a considerable time”, but did not divulge a specific timetable for raising rates.

In the wake of the news of trouble at a Portuguese bank, investors flocked to gold and U.S. and German government bonds as a temporary safe haven. The yield on the 10-year Treasury fell to 2.52% and gold closed at $1,336 an ounce. The strength in the bond market is also sending out signals that the economic recovery may not be as strong as most economists are forecasting.

For the week, the Dow Jones Industrial Average dropped 0.7% to close at 16,943 while the S&P 500 Index declined 0.9% to close at 1,967. The Nasdaq Composite Index lost 1.6% to close at 4,415.

This Week

The markets will be faced with information overload this week as economic data, earnings reports and Federal Reserve news will all be in abundance. Retail sales for June are expected to rise 0.6% on strong automobile sales and industrial production is also forecast to rise by the same percentage for the month. June housing starts should confirm an improving housing sector while leading economic indicators for June should point to a stronger, more vibrant economy. The June producer price index (PPI) is expected to rise only modestly and the July consumer sentiment index should be positive for the markets.

Fed Chair Janet Yellen will give her semiannual testimony on the state of the economy and monetary policy and most observers expect her comments to be upbeat on the economic recovery. The Fed also is scheduled to release its beige book that provides information on regional economic data.

The flood of second quarter earnings reports begins this week with announcements from JP Morgan Chase, Citigroup, Bank of America and Goldman Sachs in the financial sector, Intel, IBM and Google in the technology sector, Johnson & Johnson, Abbott Labs and Baxter International in the health care sector and General Electric, Johnson Controls and Honeywell in the capital goods sector.

Portfolio Strategy

The moment of truth arrives for the stock market as investors will be inundated with a torrent of corporate earnings reports this week that will either confirm or deny the presumed economic recovery in the second quarter. Based on mostly positive data on the U.S. economy, the widely held assumption is that GDP growth has rebounded strongly and that corporate earnings will follow suit. The question then becomes whether or not all of this favorable news is already priced into the stock market as it has risen steadily this year with a gain of almost 7%. Despite a brief pullback back in January that was quickly erased, the market has been on a relentless move higher that has resulted in a string of record highs. The longer the market goes without so much as a minor correction, the more investors become nervous and uneasy about the possibility of a bigger decline. Any negative second quarter earnings reports could cause some volatility in stock prices and possibly lead to a near-term pullback in stocks. Because it’s difficult to predict what might cause a long-awaited correction, the best course of action is to be well-diversified among the various asset classes and to have the appropriate investment objective and asset allocation based on your age, time horizon and risk tolerance.