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Stocks resilient as they climb a wall of worry

The investment business is, by definition, a business of hope. Everyone hopes that he can beat the market, even if few people actually can. – Avi Nachmany    

With news that a diplomatic solution to the crisis in Syria would be possible and that military conflict would probably be avoided, a sense of calm returned to the stock market last week. After seeing stocks drop some 4.5% from their all-time high set back on August 2nd on economic fears and Syrian concerns, stocks have rebounded and closed Friday just 1% below that level. While the stock market seems to have dodged one bullet, there are more on the way in the form of the much-anticipated Federal Reserve meeting this week and a possible government shutdown if the nation’s debt ceiling is not raised. This is not to mention the continual barrage of economic data that promises to confound and confuse investors along the way. Stocks have rallied as the economy has strengthened and the market has become comfortable with a small reduction in the amount of the Fed stimulus program. In fact, the consensus among strategists and economists seems to be Fed tapering of $10 to $15 billion in September. Many prognosticators also think that this action may already be priced into both the stock and bond markets. If this is the case, interest rates might have reached a plateau for now and the stock market could be in for further gains. We can only hope that both of these scenarios are true.

Last Week

Although the news that Syria would turn over control of its chemical weapons was the biggest single reason for the stock market rally last week, there were other economic factors that contributed to the rise. China, the world’s second largest economy, reported strong industrial production and retail sales gains and announced that its exports had jumped 7% in August. In this country, retail sales rose less that expected last month but July’s number was revised upward and cheered investors. Strength was seen in the sales of automobiles, electronics and home furnishings. Wholesale prices increased 0.3% in August but when the volatile food and energy components were stripped out, the so-called core rate of inflation was unchanged, indicating that inflation continues to be tame. Core prices have risen just 1.1% over the last twelve months.  

The Dow Jones Industrial Average also has a new look as Alcoa, Hewlett Packard and Bank of America will be replaced with Nike, Visa and Goldman Sachs. The DJIA is a price-weighted index and since the current price of the three new stocks is much higher than those being replaced, they will have a greater influence on the average going forward. 

For the week, the Dow Jones Industrial Average rose 3% while the S&P 500 gained 2% and the technology-laden Nasdaq Composite index increased 1.7%.

This Week

The suspense will finally end this week as the Federal Reserve meets to announce its plans to either taper its monthly bond-buying program or postpone it to a later date. At this point, the odds seem to favor a modest reduction of the purchases, maybe $10 to $15 billion at the most. Fed Chairman Bernanke may also try to jawbone interest rates lower by saying that economic growth will continue to be soft. Also on the calendar will be the consumer price index, expected to rise only slightly, and August housing starts and existing home sales, expected to reflect continued improvement in the housing market.

The Japanese stock market will actually be closed on Monday in observance of Respect for the Aged Day. With the baby boomers fast approaching retirement age and their golden years, maybe such a date could be added to the calendar in this country. Finally, on the earnings front, among the companies scheduled to report next week include Darden Restaurants (Olive Garden, Red Lobster), General Mills, Conagra, Fed Ex and Oracle.

Portfolio Strategy

Stocks continue to climb a wall of worry as evidenced by the Syrian situation and the recent rise in interest rates and their adverse effect on the economy. Through it all, though, the stock market has remained resilient and despite a correction of about 5% from its peak, has climbed back to regain almost all of its losses. There is still plenty of cash on the sidelines that could provide the fuel to move the market higher. Valuations are still reasonable based on earnings projections for next year and corporations have strong balance sheets, which could lead to share buybacks, dividend increases or merger and acquisition activity. The mere fact that so many investors are skeptical of the stock market and its strong year-to-date performance could also be viewed as a bullish sign for equities. Although interest rates have risen dramatically, they seem to have leveled off and by historical standards, they still remain relatively low. Only when the 10-year Treasury yield reaches 5% or above do interest rates seem to affect stocks adversely.  

The news that a diplomatic solution was reached in Syria caused the price of gold, silver and other commodities to fall last week as the threat of war was lifted and investors felt comfortable moving back into risky assets. However, with geopolitical risks in the U.S. over the debt ceiling and budget deficits, upcoming elections in Germany, complications or delays in the Syrian resolution and the Fed meeting this week, gold could become a safe haven again and a place to hide if volatility returns to the stock market. For this reason, a small allocation to commodities such as gold and silver of less than 5% of a portfolio’s market value is not a bad idea.