S&P 500 winning streak snapped over tax reform uncertainty

In this business if you’re good, you’re right six times out of ten. You’re never going to be right nine times out of ten. – Peter Lynch

After eight consecutive weeks of gains, investors decided to take some profits last week as both the S&P 500 Index and the Dow Jones Industrial Average closed modestly lower. The Nasdaq Composite Index also had its winning streak halted as many high-flying technology stocks came back down to earth. The major stock averages were due for a breather as they all have risen over 20% since the presidential election last November. The price of oil continued its winning streak, though, as it rose to over $57 a barrel for its 5^th straight weekly gain. It was a mixed bag for third quarter corporate earnings reports as retailers Macy’s, Nordstrom and JP Penney beat earnings estimates while Kohl’s profits trailed expectations. Media giant Walt Disney also missed on revenue and earnings estimates but announced that it was in talks to buy most of 21^st Century Fox. Bank stocks were also weak as the yield curve continued to flatten with the spread between the 2-year Treasury yield and the 10-year Treasury yield only about 70 basis points, the lowest level in a decade. (A basis point is one hundredth of one percent). If the yield curve becomes inverted with short-term rates higher than long-term rates, then the possibility of a recession becomes even greater. With expectations for stronger economic growth, a recession does not appear likely but the flattening yield curve does bear watching. Companies are still growing earnings, too, as third quarter earnings have grown 6.3% on a year-over-year basis. With over 85% of companies in the S&P 500 having reported quarterly earnings, about 75% of them have beaten analysts’ estimates. Probably the biggest negative for stocks last week was the disclosure of the Senate Republican tax reform plan, which would delay a corporate tax cut until 2019. The House version would implement the tax cut immediately and the uncertainty over the timing of this important piece of legislation could weigh on stocks in the near-term.

Last Week

There was very little in the way of economic data last week. The University of Michigan consumer sentiment index came in less than forecast. This index measures consumers’ attitudes on future economic prospects and the data seemed to indicate that consumers are concerned about rising inflation expectations and higher interest rates. Weekly jobless claims rose by 10,000 to 239,000, above expectations of 232,000, but still remained at levels consistent with a strong labor market.

In addition to merger talks between Walt Disney and 21^st Century Fox, Broadcom offered $70 a share or a total of $103 billion to acquire Qualcomm. But a possible merger between Sprint and T-Mobile US fell through.

For the week, the Dow Jones Industrial Average declined 0.5% to close at 23,422 while the S&P 500 Index slipped 0.2% to close at 2,582. The Nasdaq Composite Index also fell 0.2% to close at 6,750.

This Week

Both the producer price index (PPI) and the consumer price index (CPI) for October are expected to edge up slightly as inflation remains subdued. October retail sales are forecast to be flat after increasing at a healthy rate in September. Housing starts are expected to remain strong in October and industrial production is expected to top last month’s reading.

Retailers will dominate this week’s quarterly earnings reports as Home Depot, Target, Wal Mart Stores, Best Buy, TJX Companies, Dick’s Sporting Goods, Williams-Sonoma and the Gap are all scheduled to report. Other notable companies on the calendar include Cisco Systems, Applied Materials, Tyson Foods and Viacom.

Portfolio Strategy

Just as spreads have narrowed considerably between short and long-term bonds, spreads have also compressed between high-yield or junk bonds and comparable U.S. Treasuries with similar maturities. As the economy has strengthened and corporate profitability has improved, high-yield bonds have seen their prices increase and their yields plunge. (Bond prices and yields move in opposite directions). Such an environment has also been favorable for stocks as the major stock averages have returned in excess of 20% during the past year. For this reason, stocks and high-yield bonds are considered to be positively correlated and tend to move in the same direction. Since high-yield bond prices have risen so much while their yields have plummeted, investors are not being compensated enough for the risk of buying these securities. Junk bond yields now are only about 5%, far less than they have been historically. These bonds are subject to credit risk and default risk as they are rated below investment grade by the rating agencies. Although economic fundamentals are currently fairly strong and mitigate any default risk, investors still are not being paid enough with spreads this tight. With the likelihood of higher interest rates in the near future, high-yield bonds are subject to interest-rate risk as well as credit risk. At this point of the economic cycle with spreads this narrow, it’s not prudent to reach for extra yield if one is not compensated for the additional risk involved. Instead, it’s far more important to sacrifice some yield for quality and safety.