Nasdaq gains nearly 2% as technology & health care stocks surge

Acknowledge the complexity of the world and resist the impression that you easily understand it. People are too quick to accept conventional wisdom, because it sounds basically true and tends to be reinforced by both their peers and opinion leaders, many of whom have never looked at whether the facts support the received wisdom. It’s a basic fact of life that many things “everyone knows” turn out to be wrong. – Jim Rogers

The Nasdaq Composite Index was the big winner last week as it rebounded from its recent slide to post a gain of nearly 2% while the S&P 500 Index and the Dow Jones Industrial Average were basically flat. Although technology stocks sprung back to life, it was the health care sector that turned in the best performance as President Trump drafted an executive order that would reduce drug industry regulations. The big losers last week were energy stocks, utilities and financials as investors rotated out of these sectors into those that are perceived to have higher growth potential, namely health care and technology. The price of oil fell to a 9-month low and into bear market territory on news of increased production from several OPEC countries and inventory buildup in the U.S. Fears of a supply glut and slowing economic growth drove energy stocks lower, but the overall damage was limited as they only comprise about 6% of the S&P 500 Index. Financials were also weak even though the biggest banks in the U.S. passed the first part of their stress tests developed by the Federal Reserve. The tests were devised to ensure that banks have enough capital on hand to weather another financial crisis such as the one that occurred in 2008. This news would normally be positive for bank stocks, but modest economic growth and low inflation could keep the Fed from raising interest rates again this year, a move that would benefit bank net interest margins. In fact, despite the Fed rate hike the previous week, the yield on the 10-year Treasury slipped to 2.15% on Friday, only the second time this year it has been this low. With the stock market trading near all-time highs, it seems to be signaling that economic growth will accelerate and inflation will pick up. But with the 10-year Treasury yield so low (bond prices move inversely to yields), the bond market seems to be suggesting that growth will be sluggish, inflation will be low and a recession cannot be ruled out. Time will only tell whether or not the stock market has it right or the bond market has it right.

Last Week

Both existing home sales and new home sales in May were better than expected, suggesting that housing demand is strong and that the housing recovery remains intact. Leading economic indicators rose in May and reflected an economy that is still growing, albeit at a modest pace. Weekly jobless claims rose by 3,000 to 241,000, the 120^th consecutive week that claims have been below 300,000, the threshold associated with a strong labor market.

Three Federal Reserve presidents expressed dovish views on interest rates in comments made last week. Chicago Fed President Charles Evans said that the Fed could be done raising interest rates this year; Boston Fed President Eric Rosengren said that current low rates could be in place for a while and St. Louis Fed President James Bullard said the Fed should pause on hiking rates as the economy is stuck in a low-growth, low-inflation environment.

For the week, the Dow Jones Industrial Average added only about 10 points and closed at 21,394 and the S&P 500 Index edged higher by 0.2% to close at 2,438. The Nasdaq Composite Index rose 1.8% to close at 6,265.

This Week

In keeping with recent weak economic growth, durable goods orders for May are expected to fall modestly and the final reading for first quarter GDP is expected to be 1.2%. The Chicago purchasing manager’s index (PMI) for June is forecast to be slightly less than May but still solidly in expansion territory. Both the June consumer confidence index and the Michigan sentiment index should be on a par with the results in May and show that consumers are still confident about the economy.

The most prominent companies scheduled to report quarterly earnings this week include Darden Restaurants, Constellation Brands, McCormick & Co., General Mills, ConAgra, Monsanto, Walgreens Boots Alliance, Nike and Micron Technology.

Portfolio Strategy

Although bank stocks sold off last week as investors rotated back into technology and health care stocks, U.S. banks are extremely well-capitalized, thanks in large part to the stress tests required by the Federal Reserve after the financial crisis almost ten years ago. The U.S. banking industry is probably in the strongest financial condition that it has ever been and, as a result, major banks are expected to increase their dividend payout ratios considerably over the next 12 months. After the financial crisis, the Federal Reserve imposed strict guidelines on how much capital banks could return to shareholders through increased dividends and stock buybacks. Having easily met the higher capital requirements, many banks are now in a position to grow their dividends by at least 20% a year over the next several years. Not only that, but bank stocks are cheap relative to the overall market, trading at about 13 times estimated earnings for 2017 compared to over 18 times for the S&P 500 Index. Earnings growth is also expected to accelerate as net interest margins widen and loan growth improves. Expectations in the bank sector are for high-single to low-double digit profit growth this year, which is much better than in previous years. All of the major banks are expected to increase their dividend payout ratios and some will return capital to shareholders through stock buyback plans. In a market that many think is overvalued, bank stocks are attractively valued based on their solid fundamentals and dividend growth potential.