Stocks rise on strong corporate earnings

Those with the enterprise lack the money and those with the money lack the enterprise to buy stocks when they are cheap. – Benjamin Graham

The stock market overcame the tragic news of a Malaysia commercial jet being shot down over Ukraine as well as the beginning of a ground war in Gaza by Israel to close modestly higher last week. While these two events sent stocks tumbling lower on Thursday, all of the losses were regained the following day as investors chose to focus on fundamentals and second quarter corporate earnings, which have been surprisingly strong. Among the big money center banks and investment houses, JP Morgan Chase, Citigroup, Goldman Sachs and Morgan Stanley all posted earnings that beat analyst estimates. Positive results from such stalwarts such as Intel and Honeywell also contributed to the bullish sentiment and have given investors reason to be optimistic that this good news is likely to continue. In addition to the solid profit reports, the economic data released last week was generally favorable as were remarks by Fed Chair Janet Yellen on the state of the U.S. economy. She acknowledged that industrial production and consumer spending rebounded nicely during the second quarter but expressed disappointment at the strength of the housing recovery.  She even put on her investment strategist’s hat and suggested that certain sectors of the stock market were a bit frothy, namely small cap stocks, biotechnology shares and social media companies. And as she has insisted time and time again, interest rates will not be raised until the economy is unquestionably on solid footing. While the horrible events last week definitely caught investors’ attention, any repercussions are likely to be temporary and fleeting. In the final analysis, it’s economic fundamentals and corporate earnings that drive stock prices and last week proved no exception.

Last Week

For the most part, the overall economic data was positive last week. U.S. retail sales rose modestly despite the fact that automobile sales fell but core retail sales (excluding autos, gasoline, building materials and food services) rose 0.6%, a solid increase. Although industrial production rose less than forecast, the Philly Fed manufacturing data posted its strongest number in three years. The housing data was a mixed bag as homebuilder sentiment rose to a six-month high but housing starts fell, suggesting that the housing market recovery continues to sputter. Lastly, the produce price index (PPI) increased 0.4% while U.S. leading economic indicators rose 0.3%, a sign the economy is expanding.

The Fed Beige Book confirmed Janet Yellens’ remarks as it painted a relatively positive picture for the economy as consumer spending and manufacturing were up in all of the Fed districts. All of the districts expressed optimism about the outlook for future growth and noted that labor markets were also improving.

For the week, the Dow Jones Industrial Average rose 0.9% to close at 17,100 while the S&P 500 Index added 0.5% to close at 1,978. The Nasdaq Composite Index gained 0.4% to close at 4,432.

This Week

On the heels of a positive homebuilder sentiment report last week, both June existing and new home sales should be fairly good. After three consecutive higher than expected readings on consumer prices, the expectation is for the CPI to rise 0.3% in June. Durable goods orders should also register a healthy increase as non-defense airplane orders should be strong.

Approximately 150 companies in the S&P 500 Index report second quarter earnings this week, including Microsoft, Apple and Qualcomm in the technology sector, Coca Cola, PepsiCo and McDonald’s in the consumer goods sector, DuPont and Dow Chemical in the materials sector, Eli Lilly and Bristol Myers Squibb in the health care sector, AT&T and Verizon in the telecom sector and Boeing, Caterpillar and 3M in the capital goods sector.

Portfolio Strategy

One consequence of the geopolitical risk last week involving the downing of a Malaysia airliner over Ukraine and an Israeli ground invasion of Gaza was a flight to safety in the form of U.S. government bonds. Contrary to the widely held belief that Treasury yields would rise this year as the economy gains momentum, the yield on the 10-year Treasury fell to 2.44%, the lowest level in over a year. Yields on other government bonds in Japan, Germany, France and other European countries are even lower. Despite economic data that overwhelmingly confirms the view that the U.S. economy is accelerating and knowing full well that the Federal Reserve’s bond-buying program will end in October, interest rates continue to fall and frustrate investors looking to generate a decent income stream. The persistence of such low rates actually forces investors to assume more risk than they otherwise would in a more normal interest rate environment by buying below investment grade bonds and stocks in order to get a decent return. Spreads of corporate bonds to comparable Treasury securities have tightened considerably and current rates on so-called high yield bonds don’t compensate investors for the added risk. Extending maturities to obtain an incremental yield advantage is also fraught with risk in the event interest rates actually do rise sometime in the future, causing principal values to suffer. When it comes to the fixed income portion of the portfolio, the emphasis should be on quality and a short-to-intermediate term maturity structure.