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Dow climbs 507 points or 2% to close at another record high

The less prudence with which others conduct their affairs, the greater the prudence with which we should conduct our own affairs. – Warren Buffett

The stock market continued its torrid pace to start the new year with all three of the major averages posting solid gains and closing at record highs. The best performer was the Dow Jones Industrial Average, which rose 507 points last week for a gain of 2%. Investors remain optimistic about the U.S. economy and confident that corporate earnings growth will be strong. Most analysts expect earnings growth in the fourth quarter to be 11% with all 11 sectors of the S&P 500 Index reporting increases in both earnings and revenue. The fourth quarter earnings season began in earnest on Friday with four of the biggest financial names and they did not disappoint. JP Morgan Chase, PNC Financial and Blackrock all beat their earnings and revenue estimates while Wells Fargo missed its revenue target but also topped its profit forecast. Corporate tax cuts, higher interest rates and reduced regulatory burdens helped boost their bottom lines and bodes well for this week when a slew of banks are scheduled to report their earnings. Consumer spending accounts for about two thirds of all economic activity and data released last week showed that holiday sales were strong. The National Retail Federation (NRF) reported that holiday retail sales rose 5.5%, much better than expected, and Target announced that its sales were better than forecast. Consumer credit growth in November also increased by the largest monthly amount in 16 years as consumers spent heavily on their credit cards. The economy seems to be firing on all cylinders and with the benefits of tax reform and tax cuts, many analysts have raised their full-year earnings estimates. Such optimism has not been lost on investors, either, as there have been increased flows into equity mutual funds and exchange-traded funds. While much of the good news is already priced into the market, fear of missing out on any further gains has prompted many investors to climb aboard now, helping to fuel the rally.

Last Week

The producer price index (PPI) edged lower in December to record its first drop since August 2016. Core PPI, which excludes food and energy, rose only 2.3% in 2017. The December core consumer price index (CPI) posted its biggest increase since January and increased 1.8% for all of last year. Retail sales in December were not as strong as in November but still healthy and higher in 2017 than in 2016. Weekly jobless claims rose for the fourth consecutive week and were higher than expected. However, claims data tends to be volatile during the year-end holidays and data still suggest that the labor market remains strong.

For the week, the Dow Jones Industrial Average surged 2% to close at 25,803 while the S&P 500 Index rose 1.6% to close at 2,786. The Nasdaq Composite Index added 1.7% to close at 7,261.

This Week

The preliminary reading of the January University of Michigan consumer sentiment index should show its first increase in three months while December industrial production and housing starts should be consistent with the previous month’s gain. The Federal Reserve releases its Beige Book on current economic conditions across the country.

Congress must pass a funding bill by Friday or face a U.S. government shutdown and the topic of immigration will likely be a major stumbling block.

Financials will once again dominate quarterly earnings reports this week as Citigroup, Charles Schwab, U.S. Bancorp, Goldman Sachs, American Express, Morgan Stanley and SunTrust Banks are on the agenda. Other notable companies on the list include IBM, CSX, Schlumberger, UnitedHealth and Alcoa.

Portfolio Strategy

Not only have stocks risen sharply so far this year, but yields on fixed income securities have also begun an upward climb. The yield on the 10-year Treasury settled on Friday at 2.55%, compared to a yield of 2.41% at the end of last year. Yields on short-term securities have also seen a dramatic rise as the 2-year Treasury yield finished the week above 2% for the first time since September 2008. (Bond prices move inversely to yields.) Stronger economic growth, tax cuts and tax reform, slightly higher wage growth and the Federal Reserve’s rate hike forecast have all contributed to increased inflation expectations. Global central banks have also taken steps to remove the punch bowl. Last week the Bank of Japan (BOJ) reduced its government bond purchases, raising speculation that the BOJ could scale back its easy monetary policies as confidence in Japan’s growth prospects increase. Economic growth in Europe has also solidified, suggesting that the European Central Bank (ECB) will also take its foot off the gas. Because interest rates have been at historic lows for quite some time, every year economists predict that rates will move higher, only to be wrong when they don’t. While higher rates and yields are beneficial to fixed income investors since they produce additional income, the path there can be painful because bond prices decline, resulting in losses in fixed income investments. Fortunately, no one is forecasting a spike in interest rates as most economists predict that the 10-year Treasury yield will end the year at about 2.75% and certainly no higher than 3.0%. The fact that yields on comparable foreign government bonds are so much lower than yields on Treasury securities should help keep a lid on our interest rates.