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S&P 500, Nasdaq at record highs despite negative news

A man should never be ashamed to own that he has been in the wrong, which is but saying, in other words, that he is wiser today than he was yesterday. – Jonathan Swift

Stocks snapped their two-week losing streak and, in the process, both the S&P 500 Index and the Nasdaq Composite Index closed at record highs. The Dow Jones Industrial Average also posted a gain for the week and came within 35 points of eclipsing its all-time high set back in March. Despite a number of news stories that could have caused stocks to sell-off, the market chose to ignore them and proceeded to march higher. The biggest potential negative appeared in the Federal Reserve minutes of its last meeting as Fed officials all but assured investors that interest rates would be raised in June. They also laid out a plan to reduce the $4.5 trillion in securities on its balance sheet, but emphasized that the plan would be gradual. Ordinarily, the thought of higher interest rates would send investors scurrying for the exits but now investors view higher rates as a sign that the economy is getting stronger. There also were potentially damaging news reports overseas. North Korea successfully tested an intermediate-range ballistic missile, Moody’s rating agency downgraded China’s credit rating for the first time since 1989 and there was a terrorist attack in Manchester, England. Even investor’s disappointment over OPEC’s failure to extend oil production cuts did not rattle investors, although the price of oil fell below $50 a barrel. Economic data released last week was also mixed at best as durable goods orders fell in April to a 5-month low and new home sales dropped more than expected. The stock market actually might have been helped by the fact that President Trump was on his first overseas trip last week as attention was diverted away from his ongoing problems in Washington. In the face of negative news items and lackluster economic data, the stock market has proved to be very resilient. Investors and portfolio managers alike have jumped on board the rally for fear of missing out on any further gains in the market.

Last Week

As mentioned earlier, April new home sales fell over 11% but the drop was from an almost 10-year high, leading many to believe that the housing recovery is still intact as the labor market is strong and mortgage rates are still at historic lows. Existing home sales in April also declined slightly more than expected as inventory remains low amidst a housing shortage. Weekly jobless claims fell slightly but the 4-week average dropped to a 44-year low, a sign that the labor market remains healthy. On a positive note, the second reading of first quarter GDP growth was revised higher to 1.2% from 0.7%. Also, the Michigan consumer sentiment index in May was slightly better than expected.

For the week, the Dow Jones Industrial Average gained 1.3% to close at 21,080 and the S&P 500 Index rose 1.4% to close at 2,415, a new record high. The Nasdaq Composite Index jumped 2.1% to close at 6,210, also a new record high.

This Week

The most important piece of economic data this week will be the May employment report, which is expected to show that 175,000 jobs were created and that the unemployment rate remained at 4.4%. Both the Chicago Purchasing Manager’s Index (PMI) and the May ISM Manufacturing PMI are expected to be solidly above the 50 mark, a sign that both continue to expand. April construction spending should also be better than the number reported in March while May consumer confidence should remain at a high level.

The Federal Reserve releases its beige book of economic data across all of its districts on Wednesday and several Fed presidents will speak during the week on the economy and monetary policy.

Earnings growth in the first quarter has been 15% and largely responsible for the strength in the stock market. This week promises to be a quiet one for earnings as the most notable companies scheduled to report are Analog Devices, Broadcom, Ciena, Dollar General and Vera Bradley.

Portfolio Strategy

In addition to the likelihood of an interest rate hike next month, the minutes from the most recent Federal Reserve meeting showed that officials thought the economy would rebound from the weak first quarter. They also believed that the soft March inflation data was transitory and that prices would begin to rise as economic growth accelerated. Fed officials and most economists and Wall Street strategists expect at least two more interest rate hikes in 2017, most likely in June and September. The problem with this forecast is that the inflation data is not cooperating. The Fed’s preferred measure of inflation, the personal consumption expenditures (PCE) index, was up only 1.8% recently, excluding food and energy. This increase is below the Fed’s target of 2% and the core PCE index is expected to fall even further in the months ahead. Consumer price data has also been soft. While the Fed is intent on raising rates twice more this year and starting the process of reducing the securities on its balance sheet, the bond market does not think the Fed will be this aggressive and, instead, will take a more cautious approach. The current yield on the 10-year Treasury is only 2.25%, a rate that indicates inflation expectations are low and sluggish economic growth lies ahead. If the Fed is intent on raising rates at the short end of the yield curve and the long end of the curve has not moved higher, then the yield curve will tend to flatten out. The risk is that the yield curve becomes inverted, with short-term interest rates higher than long-term interest rates. Over the last 50 years, when this occurs, a recession usually ensues. The Federal Reserve will have to do a balancing act and not raise rates unless the economy is strong enough to warrant an increase, something that might be easier said than done.