Strong corporate earnings lead to gains

I will tell you how to become rich. Close the doors. Be fearful when others are greedy. Be greedy when others are fearful. – Warren Buffett

With the drama in Washington now in the rear view mirror, investors turned their attention last week to corporate earnings and economic data and apparently liked what they saw as the S&P 500 closed at yet another record high. The bond market also joined in the festivities as the yield on the 10-year Treasury fell to 2.50% as investors cheered the prospects for a continuation of a Goldilocks economy – neither too hot nor too cold but just right to satisfy the insatiable appetite of the bulls. Actually, it was the belated jobs report for September that was partly responsible for fueling the rally in both stocks and bonds. And it was a case of bad news being perceived as good news as the creation of fewer new jobs in the economy meant that the Federal Reserve would probably postpone any reduction in its stimulus program until early next year if not longer. But the probable delay in Fed tapering wasn’t the only reason why stocks continued their winning streak last week. Corporate earnings reports for the third quarter have been better than expected as profits have increased over 7% and revenue growth has topped 4%. While most of the credit for the strength in the stock market this year has been the easy monetary policies of the central bank, the ability of corporations to deliver strong earnings in the face of a tremendous amount of economic and fiscal uncertainty should not be underestimated. Ultimately, it is earnings that drive stock prices and through the peak in earnings season last week, those earnings have been surprisingly good.

Last Week

On balance, the economic data for last week could best be described as mixed. On the bright side, durable goods orders rose 3.7% in September as there was a surge in aircraft contracts. But if the volatile transportation sector was excluded from the report, orders actually dropped slightly, making it the third consecutive monthly decline. The government shutdown and political wrangling in Washington also caused consumer sentiment to fall to a level not seen since the end of last year. While the number of new jobs created was far less than expected, the unemployment rate edged down from 7.3% to 7.2% and the number of people filing for state unemployment benefits fell for the third straight week.

The news on the earnings front, though, was mostly positive as companies continued to post quarterly profits that exceeded analyst’s estimates. After the market close on Thursday, two heavyweights that trade on the Nasdaq, Microsoft and Amazon, delivered strong earnings. The next day Procter & Gamble reported an 8% earnings increase on improving sales and United Parcel Service also reported strong revenue and earnings growth, helping propel the S&P 500 to its record close.

For the week, the Dow Jones Industrial Average rose 1%, the S&P 500 Index climbed nearly 1% and Nasdaq Composite Index gained 0.7%.

This Week

Delays caused by the government shutdown will affect the October jobs report, which normally would be released on Friday. In the absence of this report, the ADP payroll numbers will likely be the focus this week. The expectation is for only about 130,000 private sector jobs to be created as the government shutdown likely affected hiring. Also on tap will be two measures of inflation, the producer price index and the consumer price index, both of which should provide evidence that inflation remains under control. Retail sales for September should show only a modest increase as automobile sales are expected to be weak.

The Federal Reserve also is scheduled to meet this week but no changes are expected in their easy monetary policy. The recent government shutdown and disappointing employment numbers likely have sealed the deal with regard to postponement of any Fed tapering. On the earnings calendar, the most anticipated report will be that of Apple Computer on Monday and it could set the tone for the week. Other reports due out include Merck and Pfizer in the health care sector, Chevron and Exxon Mobil in the energy sector and Kraft Foods, Archer Daniels Midland and Starbucks in the consumer non-durables sector.

Portfolio Strategy

With the stock market posting gains for the third consecutive week, it’s difficult to envision what might cause the rally to stall or lose its momentum to the upside. It’s been over five hundred trading days since the U.S. stock market has undergone as much as a 10% correction and during this time, the market has had to overcome a lot of obstacles in its path. With nothing foreseeable on the near-term horizon except the usual economic data and corporate earnings reports, what will cause stocks to undergo a correction is anybody’s guess. Bullish sentiment has risen the last several weeks and can act as a contrarian signal that stock prices have come too far too fast and may be due for a pullback. On a near-term basis, stocks appear to be overbought as valuations have become somewhat stretched and investors have become complacent after the resolution of the government shutdown and the debt ceiling. They figure that if stocks can withstand these headwinds, they can withstand just about anything that is thrown at them. Fund flows into equities have also been strong recently and are a sign that retail investors have climbed on board and sense that this bull market has longer to run. It’s difficult to fight the tape and with stocks still in an upward trend, investors would be wise to maintain their current equity exposure and add to their positions on any market weakness if they are underweighted in stocks.