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Stocks ride roller coaster to post modest gains as Treasury yields fall

Stock market goes up or down, and you can’t adjust your portfolio based on the whims of the market, so you have to have a strategy and not pay attention to noise that could surround any particular investment. – John Paulson, American investor and hedge fund manager

The major stock averages took investors on a roller coaster ride last week and when the ride stopped, stocks managed to post modest gains. What caused the increased volatility in the stock market were continued concerns that the Federal Reserve would tighten monetary policy faster than expected to combat rising inflation. In the Fed minutes from its January meeting released on Wednesday, Fed officials revised upward their projections for economic growth and agreed that further gradual monetary tightening would be appropriate. They cited continued labor market strength as a reason that wage growth would accelerate and believed that the core personal consumption expenditures (PCE) index would run “notably faster in 2018”. This has been the Fed’s preferred measure of inflation and it has been running below the Fed’s inflation target of 2%. Investors immediately took these comments to mean that higher inflation would translate into additional interest rate hikes and higher bond yields. The yield on the 10-year Treasury rose to 2.95%, a 4-year high and dangerously close to the 3.00% threshold. As you might expect, stocks reacted negatively on the news and closed significantly lower on the day. The stock market had a much different reaction, though, to the Federal Reserve monetary policy report that was released on Friday. This report will be used for congressional testimony by new Fed Chair Jerome Powell on Tuesday. It showed that Fed policymakers see continued strength in the labor market, moderate economic growth and gradual interest rate hikes, but probably no more than three for the year. While the Fed expects inflation to rise to its 2% target, it also noted slack in the labor market and that online retailers could be keeping prices low and holding down inflation. These more dovish remarks sent the yield on the 10-year Treasury down to 2.87% and equity investors followed by bidding up the price of stocks. At the closing bell, the S&P 500 Index had surged 1.6% and now has recouped more than half of what it had lost in the recent market correction. Thus, two distinct and separate reports from the Federal Reserve produced two different and opposite reactions from the stock market, with the net result being mildly positive.

Last Week

Leading economic indicators in January were strong as they beat expectations and were better than the increase in December. They now have registered an increase in 12 of the last 13 months. The index is based on 10 key metrics such as stock prices, unemployment claims, building permits, manufacturing orders, etc. January U.S. existing home sales fell for the second straight month due to a shortage of homes for sale, which is pushing up prices. Weekly jobless claims fell 7,000 to 222,000, less than expected, and reached a 45-year low.

The Amazon effect hit Wal Mart this past week as the giant retailer missed earnings estimates, reported a 23% drop in e-commerce revenue and saw its stock fall 10% on Tuesday.

For the week, the Dow Jones Industrial Average added 0.4% to close at 25,310 while the S&P 500 Index rose 0.6% to close at 2,747. The Nasdaq Composite Index jumped 1.4% to close at 7,337.

This Week

It will be a busy week for economic data. January new homes sales are expected to surpass the number reported in December while January durable goods orders are forecast to drop on fewer commercial aircraft orders. The second estimate for fourth quarter 2017 gross domestic product (GDP) is expected to be 2.6% and the February ISM manufacturing index is expected to fall slightly but still be solidly in expansion territory. Both the February consumer confidence index and the Michigan consumer sentiment index should remain at high levels.

Retailers will dominate the quarterly earnings results this week as Macy’s, Lowe’s, Kohl’s, Nordstrom, Best Buy, TJX Companies and JC Penney are scheduled to report. Other notable companies on the agenda include Toll Brothers, Broadcom, Analog Devices and AutoZone.

Portfolio Strategy

Two recent economic reports have led to fears that inflation may be heating up but those fears may be overblown. The January employment report showed that average hourly wages had risen at a 2.9% annual rate and the January consumer price index rose by a higher-than-expected 0.5%. Both of these inflation measures caused a big sell-off in stocks as investors jumped to the conclusion that the Federal Reserve would raise interest rates much faster than originally expected. But the Fed’s preferred measure of inflation, the personal consumption expenditures (PCE) index, has been running below its targeted rate and the Fed’s efforts to reduce its balance sheet have gone smoothly. Even though GDP growth in the first quarter could exceed 4%, longer-term GDP growth is expected to be closer to 3% or less. While the tax cuts and increased fiscal spending will boost growth and could be inflationary, their effect on the economy will take time. The Federal Reserve is committed to normalizing monetary policy by raising rates, but the federal funds rate is currently very low and there is ample room to hike rates before the economy is adversely affected. Wage growth has picked up but the increase was for just one month and both technology and globalization could help keep wage growth suppressed. Instead of reacting to current inflation data, investors seem to be overreacting to the possibility of much higher inflation, which probably will not be as bad as feared.