Stocks post modest losses on Fed official remarks

We’ve used derivatives for many, many years. I don’t think derivatives are evil, per se, I think they are dangerous. …So we use lots of things that are dangerous, but we generally pay some attention to how they’re used. We tell the cars how fast they can go. – Warren Buffett

News that the U.S. economy contracted much worse than expected in the first quarter coupled with a more hawkish tone from a Fed official caused stocks to post modest losses last week as trading volume continued to be light. In a surprising announcement midweek, the government said that final first quarter GDP fell 2.9% instead of the 1% drop it had reported the previous week. This was the economy’s worst performance in five years and caused a lot of jaws to drop, despite the fact that it’s old news and largely attributed to the severe winter weather. Much of the more recent economic data suggests that the economy is rebounding strongly, although many economists have tempered their enthusiasm somewhat after the anemic first quarter. The consensus now believes that second quarter GDP will be about 3%, meaning the first half of the year will show no growth whatsoever. Remarks by St. Louis Federal Reserve President James Bullard also unnerved markets when he predicted that the Fed timetable for raising interest rates would come sooner than anticipated, possibly as early as the end of the first quarter in 2015. He also expressed optimism about the strength of the economy and thought that GDP growth would be 3% for the next four quarters. After hovering at all-time highs, the stock market was probably due for a breather and investors used Bullard’s comments as a convenient excuse to sell and lock in some profits. After all, rising interest rates sooner rather than later could prove problematic for stocks.

Last Week

Apart from the weak first quarter GDP report and Fed President Bullard’s remarks, the economic data was generally favorable last week, especially for the housing sector. U.S. existing home sales were up almost 5% in May, which was the biggest increase in seven months. New home sales were also strong as they jumped 19% to a six-year high in May. Much of the strength in the housing data was due to a stronger labor market, larger inventories and declining mortgage rates.

Consumer confidence numbers were also better than expected, which bodes well for the future direction of consumer spending, which accounts for more than two thirds of U.S. economic activity. Jobless claims fell slightly last week and suggest that the recent payroll job gains are likely to continue. Overseas, Japanese Prime Minister Shinzo Abe introduced a series of economic reforms designed to increase economic growth and boost corporate profitability.

For the week, the Dow Jones Industrial Average lost 0.6% to close at 16,851 while the S&P 500 Index shed 0.1% to close at 1,961. The Nasdaq Composite Index bucked the trend and rose 0.7% to close at 4,397.

This Week

With Independence Day on Friday and the U.S. markets closed, the June employment report on Thursday will definitely be the highlight for the week. Expectations are for the unemployment rate to remain unchanged at 6.3% and for 215,000 new jobs to be created, in keeping with the year-to-date average non-farm payroll number. The June Chicago purchasing managers report should also be strong and automobile sales should remain over a 16 million annual pace for the month. Both the Institute for Supply Management (ISM) manufacturing index and construction spending are expected to confirm better growth as well.

There are only a few companies scheduled to report quarterly earnings this week and none of them are household names. Second quarter earnings reports will begin in earnest the week of July 7^th with Alcoa leading the parade.

Portfolio Strategy

As we head into the second half of the year, most investment strategists agree that relative to cash and fixed income investments, equities remain the most attractive asset class. Despite the fact that this bull market has lasted more than five years, longer than the average of the last eleven bull markets, stocks still offer more upside potential. From current levels, though, it appears that any additional gains between now and year-end could be limited. The biggest risks for the stock market appear to be recession and its effect on corporate earnings and the possibility of interest rates rising faster and higher than expected. While the probability of the former seems remote given the rosy projections by economists for GDP growth in the second half of the year, the likelihood of the latter seems plausible if growth accelerates and inflation rises. The Federal Reserve could be forced to raise rates sooner than expected, which could spook the stock market and cause bond prices to fall. Not only would bonds be hurt, but interest-rate sensitive stocks such as utilities and telecom stocks would suffer, too. In addition, geopolitical risks in the Middle East involving Iraq or Libya could affect world oil markets and cause oil prices to spike, leading to slower growth and higher inflation. Investors may have been lulled into a false sense of security with interest rates near zero, inflation worldwide almost nonexistent and global central bank policies still accommodative. But if the Fed begins to tighten faster and sooner than thought, stocks could lose some of their relative appeal.