Strong momentum powers S&P 500 to record high

Individuals who cannot master their emotions are ill-suited to profit from the investment process. – Benjamin Graham

Driven by continued strong momentum by the market’s best-performing stocks, all three of the major stock averages closed at record high levels last week. It was the eighth consecutive weekly gain for the Dow Jones Industrial Average and the S&P 500 Index while the Nasdaq has been up for six straight weeks. October was anything but scary as the Dow was up 4.3% for the month and the Nasdaq was up 3.6%. All three benchmarks seem immune from the laws of gravity as valuations have become increasingly stretched. The technology sector has been the best-preforming sector this year and more than half of the S&P 500 gains have come from just five of these stocks, namely Facebook, Amazon.com, Apple, Alphabet (parent company of Google) and Microsoft. Two of these stocks, Facebook and Apple, reported much better than expected revenue and earnings last week, providing the catalyst for further gains in the broad market. With more than half of S&P 500 companies having reported third quarter earnings, nearly 75% of them have beaten earnings estimates. Favorable quarterly earnings reports weren’t the only reason for the strong showing of the stock market. Economic data was also positive, including the October employment report which showed that 261,000 new jobs were created and that the unemployment rate dropped to 4.1%. Although the number of jobs was less than expected, it was a huge improvement over the weak jobs number in September due to the devastating effects from Hurricanes Harvey and Irma. The only negative in the employment report was that average hourly earnings remained flat, an anomaly given the fact that the labor market remains very tight. The Federal Open Market Committee (FOMC) was also sanguine about the economy. As expected, it decided to leave interest rates unchanged but commented that the economy was improving at a “solid rate”. Even though the inflation rate is running below 2%, the Fed seems prepared to raise interest rates in December and expectations are nearly 100% for a rate hike. With the stock market setting record highs on almost a weekly basis, the question arises about what might cause a correction. Unfortunately, the best answer is that no one knows and one should probably expect the unexpected.

Last Week

All of the economic data released last week was positive. The ISM manufacturing index was slightly less than expected but still very strong as global economies are improving and the cheaper dollar is boosting exports. The ISM non-manufacturing index or services sector index was better than expected and at the highest level since August 2005. September factory orders were strong and construction spending in October improved at a healthy rate, led primarily by public works and housing. Other jobs data was also favorable as the ADP private sector payrolls showed an increase of 235,000 jobs and weekly jobless claims fell by 5,000 to 229,000.

President Donald Trump named Fed Governor Jerome Powell to succeed Janet Yellen as chairman of the Federal Reserve, but no major monetary policy changes are expected to occur. The Republicans in the House of Representatives unveiled their tax-reform plan and it calls for a cut in the corporate tax rate from 35% to 20% and consolidation of individual tax brackets into zero, 12%, 25% and 35%, with those earning over $1 million at 39.6%. The difficult task now will be producing a bill that can be passed by both the House and the Senate.

For the week, the Dow Jones Industrial Average added 0.4% to close at 23,539 while the S&P 500 Index gained 0.3% to close at 2,587. The Nasdaq Composite Index rose 0.9% to close at 6,764.

This Week

It will be a slow week for economic data as the only important piece of data is the November University of Michigan consumer sentiment index, which is expected to remain high as consumers continue to be optimistic about the economy and the labor market.

On his trip to Asia, President Donald Trump will meet with the Prime Minister Shinzo Abe of Japan, South Korean President Moon Jae-in and Chinese President Xi Jinping.

Among the most prominent companies scheduled to report earnings this week are Sysco, Walt Disney, CVS Health, Humana, Marriott International, Emerson Electric, Johnson Controls, D.R. Horton, Nordstrom, Macy’s and Kohl’s.

Portfolio Strategy

The naming of Jerome Powell to succeed Janet Yellen as Chairman of the Federal Reserve last week coincided with a decline in the 10-year Treasury yield to 2.34% from 2.47% just a week ago. In recent weeks, the spread between long bond yields (10-year Treasury) and short bond yields (2-year Treasury) has narrowed significantly and resulted in a flattening yield curve. Not since 2007 has the yield curve been this flat. The Fed is widely expected to raise interest rates in December and has forecast three additional rate hikes in 2018. A flattening yield curve can lead to an inverted yield curve where the short end is higher than the long end, a foreboding sign that suggests the possibility of a recession. While the short end yield of 1.63% for the 2-year Treasury reflects Fed rate hike prospects, the long end decline reflects a lack of inflation in the economy. The October jobs report that showed no signs of wage growth was further evidence that inflation remains relatively benign and below the Fed’s 2% target. The current yield curve may suggest that a recession is around the corner, but improving global economies and stronger U.S. economic growth would suggest a steepening yield curve, provided inflation begins to accelerate.