Strong earnings boost major averages to fresh all-time highs

Never adopt permanently any type of asset or any selection method. Try to stay flexible, open-minded and skeptical. – John Templeton

As if to sound like a broken record, the stock market rose again last week and has not suffered a down week yet this year. All three major averages surged at least 2% and ended the week at fresh all-time highs. This has been the best start for the market in over 30 years and the strongest showing since 1987. The S&P 500 Index has now set a record for the number of new highs in January and the month is still not over yet. History says that when the stock market has been this strong for the first week and the first month of the year, the market’s track record for the balance of the year is excellent. The fact that the S&P 500 is already up more than 7.5% in January bodes well for the rest of 2018. It’s no surprise that stocks have done so well this year as fourth quarter corporate earnings have been excellent. Of the S&P 500 companies that have reported their earnings results, nearly 80% of them have beaten both earnings and revenue estimates. Overall profit growth has also been impressive as S&P 500 earnings have grown an average of about 13%. Last week, blue chips such as Caterpillar, Intel, Johnson & Johnson, Procter & Gamble, 3M and United Technologies all surpassed expectations. Many companies are raising earnings estimates for the first quarter, too, as corporate tax cuts should be a boon to the bottom line. Those investors who had been waiting for a correction to enter the market have now thrown in the proverbial towel for fear of missing out on any further gains in stocks. The stock market was overvalued at the beginning of year and valuations have become even more stretched. While stocks have not quite entered the euphoric stage, they are getting close. Stocks that are already richly valued can become even more so as investors chase the market in the hope that the rally will continue. With the stock market overbought and enthusiasm building, it is time for investors to be cautious and somewhat defensive in their equity allocations.

Last Week

Leading economic indicators for December were better than expected as momentum from tax reform continued to build. Durable goods orders for December were also much better than expected and at the best levels since June. However, fourth quarter gross domestic product (GDP) rose 2.6%, less than the 3% that was expected, as imports rose at the fastest pace in more than 7 years and subtracted from GDP. Consumer spending was particularly strong during the quarter and the personal consumption expenditures (PCE) index rose 1.9% in the fourth quarter, the fastest pace in more than a year. This is the Federal Reserve’s preferred measure of inflation. Finally, both existing and new home sales in December were below estimates as the supply of homes for sale dropped. Both figures can be volatile from month-to-month.

For the week, the Dow Jones Industrial Average jumped 2.1% to close at 26,616 while the S&P 500 Index climbed 2.2% to close at 2,872. The Nasdaq Composite Index surged 2.3% to close at 7,505.

This Week

The most anticipated piece of economic data this week will be the January employment report, which is expected to show that 170,000 new jobs were created and that the unemployment rate remains at 4.1%.  The ISM manufacturing index for January is forecast to edge lower but still show strong expansion while the January Chicago Purchasing Manager’s Index (PMI) is expected to also decline slightly but remain comfortably above 60, a positive indicator for growth. The January consumer confidence and Michigan sentiment indexes should remain elevated as consumers remain very optimistic about the economy.

President Trump delivers his first State of the Union address on Tuesday night while outgoing Fed Chair Janet Yellen presides over her last Federal Open Market Committee (FOMC) meeting. No interest rate hike is expected.

This will be the busiest week for quarterly earnings reports as McDonald’s, Visa, Pfizer, Merck, Amgen, AT&T, Automatic Data Processing, Boeing, Microsoft, Facebook, Apple, Alphabet (Google), Amazon.com, Chevron and Exxon Mobil are just a few of the most notable companies on the list.

Portfolio Strategy

Despite all of the positive economic data lately and the strong fourth quarter earnings results, there are worrisome signs with the stock market rally this year. One of the most troubling indicators has been the tremendous amount of money that has flowed into the stock market. Equity mutual funds and exchange-traded funds have seen record flows of cash this month and that money has been used to purchase stocks, driving up their prices. This measure of fund flows is generally considered a contrary indicator and a sign that the stock market may be becoming too overheated. In less than one month, the S&P 500 Index has posted a total return of 7.5%. By contrast, the average gain over the last four months of 2017 was only 2% while the first eight months of last year averaged a gain of just over 1%. The last time that the stock market had a January this good was 1987, when the S&P 500 was up 13%. That was the year that the stock market crashed on October 19^th with a one-day loss of over 22%. While the market recovered that year to post a low single digit gain, it was a sobering reminder how volatile and unpredictable the stock market can be. For this reason, it is prudent for investors to periodically rebalance their portfolios when the equity allocation becomes overweighted relative to their investment objective and their tolerance for risk.