S&P 500, Nasdaq edge lower as Federal Reserve hikes rates

Value investing is at its core the marriage of a contrarian streak and a calculator. – Seth Klarman

The fact that both the S&P 500 Index and the Nasdaq Composite Index ended last week virtually flat should be viewed as positive considering the Federal Reserve has become more hawkish and economic data was mostly weaker than expected. It was certainly no surprise that the Federal Open Market Committee (FOMC) in their meeting last week reached a unanimous decision to raise the targeted federal funds rate by 25 basis points to a range between 0.50% and 0.75%. The last time the Federal Reserve raised interest rates was a year ago in December 2015. Going into the FOMC meeting, the odds of an interest rate hike were greater than 95 percent. What was a surprise to investors was the prediction by the Fed of three interest rate hikes in 2017, up from two that had been previously forecast. While this change was not anticipated by the market, the Fed was also quick to point out that any path higher would be gradual and dependent on the economic data. Fed officials expect GDP growth to average 2% over the next three years which, if true, should allow for only gradual tightening. But given this more hawkish view on the part of the Fed, the fact that the stock market did not relinquish any of its post-election gains should be viewed positively. Economic data released last week was also generally disappointing, another reason why flattish stock market performance should be considered a win. Retail sales in November were only up 0.1%, less than expected, as automobile sales recorded their largest drop in eight months. Even excluding autos, which account for about 20% of all retail spending, retail sales were still on the soft side. This news is definitely not good for retailers as the holiday shopping season winds down with less than a week to go until Christmas.

Last Week

In addition to weak retail sales, U.S. industrial production in November was also weaker than expected as there was a steep drop in utility output and a larger than forecast decline in manufacturing. Import prices fell in November due to a strong dollar and falling energy prices while the producer price index (PPI) for November rose 0.4%, higher than expected. The November consumer price index (CPI) rose modestly as expected and has now risen 1.7% over the last year, below the Federal Reserve target inflation rate of 2%. U.S. housing starts were also well below forecast in November but this data can be very volatile from month-to-month.

In overseas news, Russia and other non-OPEC oil producers agreed to reduce oil output in order to help boost the price of oil. A Chinese Navy warship seized an underwater U.S. drone used by an oceanographic vessel in international waters and stocks traded modestly lower as soon as the news hit the wires.

For the week, the Dow Jones Industrial Average added 0.4% to close at 19,843 while the S&P 500 Index edged lower by 0.1% to close at 2,258. The Nasdaq Composite Index also lost 0.1% to close at 5,437.

This Week

There will be a number of economic indicators released this week, including November existing home sales and new home sales, both of which should be at levels consistent with the previous month and indicative of a steadily improving housing sector. The final reading for third quarter gross domestic product (GDP) should show growth of 3.2%. November durable goods, which also can be volatile from month-to-month, are forecast to decline by almost 4% after increasing over 4% in October. The final December University of Michigan consumer sentiment index should post a reading of 98 as consumers remain optimistic about the prospects for the U.S. economy.

Among the most prominent companies scheduled to report quarterly earnings this week are General Mills, Con Agra, Nike, CarMax, FedEx, Accenture, Micron Technology, Lennar, Bed Bath & Beyond and Darden Restaurants.

Portfolio Strategy

The Dow Jones Industrial Average bucked the trend last week by closing higher and is now up over 13% this year, posting a better return than the S&P 500 Index and the Nasdaq Composite Index. With last week’s gain, the Dow is now within striking distance of 20,000, less than 1% away from the historic mark. While the S&P 500 Index has become the most widely used benchmark for comparative purposes, the Dow Jones Industrial Average is probably more familiar and recognizable, mostly due to the fact that it consists of just 30 stocks. The Dow’s average is calculated based solely on the stock prices of the companies that make up the index, with more weight given to those companies with the highest-priced shares. In fact, about 40% of this year’s gain in the Dow can be attributed to three stocks: Goldman Sachs, UnitedHealth Group and Caterpillar, all of which have relatively high stock prices. Since the election, four financial stocks in the Dow, namely JP Morgan Chase, Goldman Sachs, American Express and Travelers, have been largely responsible for the index’s strong showing. Unlike the S&P 500 Index, all of the companies in the Dow currently pay a dividend and the average dividend yield is slightly higher at 2.4% compared to 2.2% for the S&P 500. The price earnings ratio of the Dow is also less than that of the S&P 500 as the Dow is more heavily weighted in financial and industrial names. The widespread popularity of passive investing has made the S&P 500 the index of choice among investors. It also is more representative of corporate America as it consists of 500 different companies compared to only 30 in the Dow Jones Industrial Average.