Dow closes at record high on strong earnings

In my whole life, I have known no wise people (over a broad subject matter area) who didn’t read all the time – none, zero… You’d be amazed at how much Warren (Buffett) reads – at how much I read. My children laugh at me. They think I’m a book with a couple of legs sticking out. – Charlie Munger

The Dow Jones Industrial Average rebounded last week to post a healthy gain of over 1% on the strength of continued stellar second quarter corporate earnings reports from the blue chips. The previous week saw the Dow decline while the Nasdaq Composite Index and the S&P 500 posted solid gains. The S&P 500 Index was virtually flat last week and the Nasdaq was down slightly. The two biggest contributors to the Dow’s advance were Caterpillar and Boeing, both of which reported earnings that easily beat analysts’ estimates. Not only was Boeing responsible for much of the Dow’s gain, but the company accounted for nearly the entire gain of 6.5% in the June durable goods orders, which was better than expected and at a 3-year high. To be sure, the technology sector continues to be the best performing sector of the market with a year-to-date gain in excess of 20%, but earnings results from the big technology companies were mixed last week. While Facebook beat on both the top and bottom lines and topped 2 billion users, Amazon.com missed badly on earnings even as it beat revenue estimates. Alphabet (Google) managed to post better than expected earnings but its profit was lower due to a huge fine it paid to the European Union (EU). Each of these stocks reacted differently to the earnings news with Facebook shares rising, Google essentially flat and Amazon.com falling, but the net effect on the Nasdaq was virtually nil. The other important news event last week was the Federal Open Market Committee (FOMC) meeting and the results were as expected. The Fed decided to leave interest rates unchanged but said that the unwinding of its balance sheet will start “relatively soon” even though it acknowledged that inflation remains below its 2% target. The reduction in its securities portfolio could start as early as September. With about 180 S&P 500 companies reporting earnings last week, it marked the busiest week of the earnings season and the impressive results so far have provided a strong underpinning for the stock market as the month of July comes to an end.

Last Week

The advance reading of second quarter gross domestic product (GDP) was 2.6%, considerably better than the 1.4% growth in the first quarter and basically in line with estimates. The International Monetary Fund (IMF), however, lowered its forecast for U.S. economic growth in 2017 and 2018 due to expected tightening by the Federal Reserve. Housing data was mixed as existing home sales in June fell nearly 2% while new home sales rose nearly 1%. Consumer confidence in July hit its second highest level since 2000 and the University of Michigan consumer sentiment index for July also topped expectations.

The price of oil rose nearly 9% to $49.71 a barrel, its best week since December, as Saudi Arabia agreed to cap its exports and OPEC announced that it might penalize those members that aren’t complying with its efforts to limit production.

For the week, the Dow Jones Industrial Average rose 1.2% to close at 21,830 while the S&P 500 Index was virtually flat and closed at 2,472. The Nasdaq Composite Index edged down 0.2% to close at 6,374.

This Week

The most significant piece of economic data this week will be the July employment report. The total number of new jobs is expected to increase by about 180,000 and the unemployment rate is expected to decline slightly to 4.3% from 4.4%. Both numbers would be indicative of a strong labor market. The July Chicago Purchasing Manager’s Index (PMI) is forecast to fall from the reading in June but still show solid expansion. June factory orders should rebound strongly from those reported in May and June construction spending is expected to show a modest increase.

Corporate earnings growth has been 10% in the second quarter and favorable earnings results should continue again this week. Among the most notable companies on the earnings agenda are Apple, Allstate, MetLife, Archer Daniels Midland, Kellogg, Pfizer, Berkshire Hathaway, Duke Energy, Devon Energy, Viacom, Time Warner and Emerson Electric.

Portfolio Strategy

The key takeaway from the Federal Open Market Committee (FOMC) meeting last week was not the fact that interest rates remain unchanged, but that the Fed plans to begin the process of shrinking its balance sheet, possibly as soon as September. The Fed has already raised interest rates twice this year and most economists expect one more rate hike between now and year-end. Despite these tightening measures, the yield on the 10-year Treasury has barely budged. The yield on the 10-year Treasury at the start of the year was 2.45% and the yield now is 2.29%, a drop of just 16 basis points. Although the Trump administration’s pro-growth policy agenda has failed to materialize, U.S. economic growth has still improved and global growth has also accelerated, especially in Europe. Interest rates have remained stubbornly low primarily because inflation has been almost non-existent, but that could change in the months ahead. Oil prices have recently spiked higher and even though the health care bill failed to pass, there is a much better chance that tax reform and tax cuts will be implemented. This would mean more economic stimulus and faster growth and, presumably, higher inflation. While the Fed seems confident that it can reduce the securities on its balance sheet in an orderly fashion, there is a chance that things do not go smoothly. But even if inflation does head higher, it’s difficult to see the yield on the 10-year Treasury ending the year much higher than 2.50% or 2.75%.