Stronger than expected earnings boost stock prices

We don’t have to be smarter than the rest. We have to be more disciplined than the rest. – Warren Buffett

All three of the major stock averages hit record highs last week but only the S&P 500 Index and the Nasdaq Composite Index finished in positive territory. The Nasdaq was so strong that it posted its first 10-day winning streak since February 2015. The Dow Jones Industrial Average declined slightly as Goldman Sachs reported a big decline in its trading revenue and General Electric reported a steep drop in second quarter revenue and issued a downbeat outlook for full year earnings. Both companies are included in the Dow. For the most part, the rest of the earnings reports last week were favorable and were the main reason why stocks continued their upward trend. About 20% of S&P 500 companies have reported second quarter earnings so far and nearly 75% of them have beaten analyst estimates. Even more impressive is the fact that just over 70% of these companies have also topped revenue expectations. While it will be difficult for second quarter earnings growth to match the 15% rise in the first quarter, most analysts seem to be comfortable with profit growth of about 9%. Earnings of S&P 500 companies will be helped by a weaker dollar, which has fallen since the first of the year and will benefit multi-national companies that export their products overseas. Not surprising, many analysts have raised their full-year S&P 500 earnings estimates as the dollar has weakened and have also raised their year-end targets for this benchmark. These upward revisions have occurred despite a loss of confidence in the ability of the Trump administration to forward its pro-growth policy agenda. At a time when investors could become distracted with all of the chaos and confusion in Washington, it is important to remember that earnings are what drive stock prices. And so far the news on the earnings front has been excellent.

Last Week

It was a relatively slow week for economic data as quarterly earnings took center stage. Housing starts were strong and better than forecast, hitting their highest level since February. However, the National Association of Home Builders (NAHB) home builder sentiment index fell to its lowest level in 8 months due primarily to the rising cost of materials, especially lumber. The leading economic indicators for June were better than expected and a sign that growth could accelerate in the months ahead. Weekly jobless claims also fell by 15,000 to 233,000, the lowest level in nearly 44 years.

In overseas news, China reported 6.9% growth in the second quarter, which exceeded expectations, and the European Central Bank (ECB) left interest rates unchanged. ECB President Mario Draghi said that policymakers will discuss possible changes to their bond-buying program in the fall.

For the week, the Dow Jones Industrial Average slipped 0.3% to close at 21,580 while the S&P 500 Index rose 0.5% to close at 2,472. The Nasdaq Composite Index added 1.2% to close at 6,387.

This Week

The advance reading for second quarter GDP is expected to be 2.7%, much better than the 1.4% registered in the first quarter. Both June existing home sales and new home sales should be at levels in line with the previous month and consistent with an improving housing market. Durable goods for June are also expected to be fairly strong after falling in May.

The Federal Open Market Committee (FOMC) has a two-day meeting this week and will make a decision on interest rates. Most people expect rates to remain unchanged and an announcement could be made on the Fed’s timetable for reducing the securities on its balance sheet.

It will be another busy week on the earnings calendar and the most prominent companies that are scheduled to report include Alphabet (Google), Facebook, Intel, Amazon.com, AT&T, Verizon, McDonald’s, Coca Cola, Procter & Gamble, 3M, Caterpillar, Du Pont, Boeing, Amgen, Merck, Ford Motor, Exxon Mobil and Chevron.

Portfolio Strategy

With the major stock averages hitting record highs last week and earnings season off to an excellent start, it appears that the stock market has only one way to go and that is up. However, it is times like these when investors should exercise caution and be mindful of potential risks in the market. Right now the five largest stocks in the S&P 500 (Apple, Google, Microsoft, Amazon.com and Facebook) comprised about 13% of the S&P 500 in June and collectively trade at 26 times forward earnings, much higher than the market multiple of about 18 times. Market sentiment has also become very bullish as only about one quarter of respondents in a recent survey were bearish. Prices of so-called “safe” investments such as high dividend stocks have become expensive and low volatility funds have become popular with investors who don’t mind paying up for more risk-averse investments. Recently there has been a huge shift in the way portfolios are allocated as investors have sold U.S. equity mutual funds and piled into international funds and ETFs. While emerging markets have performed very well this year, some of them are also becoming pricier and fully valued. The popularity of passive investing relative to active management is also clearly evident as ETFs and index funds have outperformed over the long run. But will investors cut and run from their ETFs at the first sign of trouble in the markets? Finally, one of the biggest concerns for the markets has been how quiet they have been with not so much as a 5% correction in the longest time. The volatility or fear index has been virtually dead and investors have been too complacent as the market proceeds to make new highs on a regular basis. Even though the outlook for stocks appears favorable, investors should not let their guard down and should be beware of potential pitfalls that might increase volatility.