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Stocks rebound strongly following 10% correction

In the business world, the rearview mirror is always clearer than the windshield. – Warren Buffett

After plunging by more than 10% the previous week from its all-time record high set back on January 26th, the S&P 500 Index rebounded last week with its best performance in more than five years. This benchmark has now risen for six consecutive sessions and posted a gain of more than 4% last week. The Dow Jones Industrial Average and Nasdaq Composite Index also rallied to register strong gains. The fact that stocks came roaring back was a bit perplexing since inflation data released last week was worse than expected. Most investment strategists attributed the stock market correction to inflation fears caused by higher wage growth in the January employment report. They concluded that increased inflation expectations would lead to higher interest rates, creating headwinds for the economy and the stock market. Yet all of the inflation data pointed to higher inflation, not lower inflation. The consumer price index (CPI) was higher than anticipated as there were broad-based increases in gasoline, clothing, shelter, medical care and food. Although the producer price index (PPI) came in as expected, the increase was elevated and there were big increases in the cost of gasoline and health care. In the 12 months ended in January, the PPI has risen 2.7%, above the Federal Reserve’s targeted inflation rate of 2%. Import prices in January were also much higher than forecast and posted the biggest increase since April 2017, mostly due to higher oil prices. This inflation data, coupled with a tightening labor market, a weak dollar and fiscal stimulus that includes tax cuts and increased government spending, could be a sign that inflation is heating up and a precursor for higher interest rates down the road. As it was, the yield on the 10-year Treasury rose to 2.88% at week’s end, its highest level in a long time and much higher than 2.41% at the start of the year. Any further moves higher could be problematic for stocks and lead to even more volatility. The S&P 500 experienced only eight 1% moves either higher or lower last year and we’ve already had ten such moves this year – and it is only February.

Last Week

As strange as it may sound, weaker than expected retail sales in January may have contributed to the strong stock market showing last week. Retail sales posted their biggest drop in nearly a year and may have tempered inflation expectations by indicating slowing consumer spending and growth. The National Federation of Independent Businesses (NFIB) index of small business optimism was better than expected in January as business owners were sanguine about lower corporate taxes and reduced government regulations. The University of Michigan consumer sentiment index in February also exceeded expectations. January housing starts easily beat forecasts and were at the second highest level since the Great Recession. Weekly jobless claims were in line with estimates and at levels associated with a strong labor market.

For the week, the Dow Jones Industrial Average climbed 4.3% to close at 25,219 while the S&P 500 Index also rose 4.3% to close at 2,732. The Nasdaq Composite Index jumped 5.3% to close at 7,239.

This Week

It will be an uneventful week for economic data as January existing home sales are expected to be at approximately the same levels as December and January leading economic indicators should post a moderate increase in line with the previous month.

Among the most prominent companies scheduled to report quarterly earnings this week are Duke Energy, Devon Energy, Southern Company, Fluor, Genuine Parts, Newmont Mining, HP, Home Depot, Wal Mart, Hormel Foods, Medtronic and Berkshire Hathaway.

Portfolio Strategy

If inflation expectations were not bad enough already, last week’s higher than expected increase in consumer prices raised more concern over rising inflation. While investors cheered the passage of corporate and individual tax cuts, the downside of such cuts could be fewer government tax receipts and wider budget deficits. Throw in a new budget deal recently passed by Congress that increases spending by over $400 billion and talk of an infrastructure spending bill and it’s easy to see why the federal debt could balloon, increasing the supply of Treasury debt and causing interest rates to rise. A weak dollar also makes imported goods more expensive, putting additional upward pressure on prices. For individual investors, the rise in interest rates since the start of the year as produced losses in fixed income portfolios, ranging from 5% to 6% for long-term bonds to less than 1% for short-term bonds. Intermediate-term bonds have lost about 2.5% while high yield bonds have been relatively stable with losses of about 1%. Investors in high yield bonds typically demand higher yields to compensate them for the additional risk of these securities over Treasuries. The fact that the high yield bond market has held up so well is a testament to the strength of the economy and corporate balance sheets. Faced with the possibility of higher interest rates, there are several things that fixed income investors can do to mitigate the risk. A simple ladder of maturities allows for bonds to come due at different times, providing investors an opportunity to reinvest bond proceeds at presumably higher rates, providing additional income. Investors should also diversify their bond portfolios by type of security and keep bond maturities in the short-to-intermediate term range to protect against principal erosion in the event that interest rates do rise faster than expected. By holding a well-diversified mix of high quality bonds or bond funds with reasonable maturity structures, investors should be able to weather the storm in a rising interest rate environment.