Despite strong quarterly earnings, S&P 500 closes flat

If past history was all there was to the game, the richest people would be librarians. – Warren Buffett

Despite continued strong first quarter corporate earnings reports and positive economic data, the major stock averages were little changed last week. Both the Dow Jones Industrial Average and the Nasdaq Composite Index closed modestly lower while the S&P 500 Index was virtually flat. Nearly 80% of S&P 500 companies that have reported earnings for the first quarter have exceeded expectations, but investors have not been impressed as stocks have traded sideways. Last week marked the busiest week of the earnings season and, for the most part, companies have rewarded investors with strong revenue growth, too. Earnings results were particularly impressive for technology companies as Alphabet (Google), Facebook, Amazon, Microsoft, Intel and Advanced Micro Devices all managed to beat profit expectations. The good news was not confined to the technology sector, either, as Caterpillar, Boeing, United Technologies, Verizon and Coca Cola also topped estimates. Many of these same companies also increased their earnings estimates for the second quarter. To be sure, much of this good news may have been already reflected in stock prices or investors felt that earnings may have peaked and could not possibly get any better. Whatever the reason for the market’s tepid response, investors were left scratching their heads and wondering what comes next. In fact, the only negative development during the past week was the rise of the 10-year Treasury yield to 3.02%, but it fell back to 2.96% by the time the bond market closed on Friday. The dramatic increase from 2.83% just two weeks ago to over 3% last week may have spooked investors who are concerned about inflation expectations, stronger economic growth and additional tightening by the Federal Reserve. Although higher interest rates will definitely provide a headwind for stocks, the economy should continue to expand and profits should continue to grow, a combination that should be supportive of stock prices.

Last Week

New home sales and existing home sales in March were both better than expected as new home sales hit a 4-year high. The S&P/Case-Shiller Home Price Index eclipsed its peak set back in 2006 as lean supply and strong demand boosted home prices. March orders for durable goods also exceeded expectations as there was a big increase in orders for Boeing planes. The U.S. economy grew by 2.3% in the first quarter compared to an expected gain of 2%. Weekly jobless claims fell 24,000 to 209,000, which was the lowest level in nearly 50 years. Consumer confidence in April was higher than expected and at the highest level in 18 years.

The European Central Bank (ECB) kept interest rates unchanged and reaffirmed that additional monetary stimulus will be provided to the economy in the euro zone.

For the week, the Dow Jones Industrial Average dropped 0.6% to close at 24,311 while the S&P 500 Index finished flat at 2,670. The Nasdaq Composite Index declined 0.4% to close at 7,119.

This Week

March construction spending and factory orders are both expected to improve upon February’s results while the April Chicago purchasing manager’s index (PMI) is forecast to be comfortably in expansion territory above 50. The employment report for April is expected to show that 188,000 new jobs were created and that the unemployment rate has slipped to 4.0% from 4.1%.

The Federal Open Market Committee (FOMC) is scheduled to meet this week and no increase in interest rates is expected. Investors will be looking for clues in the Fed’s statement on the next rate hike, which is widely expected to be in June.

Among the companies scheduled to report earnings this week are McDonald’s, Archer Daniels Midland, Yum Brands, Merck, Pfizer, Celgene, CVS Health, Apple, Automatic Data Processing, Emerson Electric, Berkshire Hathaway, MetLife, MasterCard, Devon Energy and Consolidated Edison.

Portfolio Strategy

Not only did the yield on the 10-year Treasury hit the psychological level of 3% last week for the first time since January 2014, but the yield on the 2-year Treasury climbed above 2.5% for the first time since September 2008. Even though the 10-year yield fell back below 3% on Friday, the initial move higher may have been enough to keep the stock market in check. A similar move in the 10-year Treasury yield above 2.9% back in February was partly responsible for a 10% correction in the stock market. Higher interest rates could be a sign that the economy is strengthening, although the 2.3% first quarter growth was less than the annualized growth of about 3% in the previous two quarters. But higher rates could also pose an obstacle to the bull market in stocks as low rates and easy Federal Reserve monetary policies have contributed to some of the market’s advance. Now that the Fed has begun to reduce its balance sheet and gradually raise rates, short-term rates have also risen, making the yield curve flatter. The difference between the yield on the 2-year Treasury and the 10-year Treasury is now only about 50 basis points or half of one percent. At the end of 2016, the spread was more than twice that. Inflation may be under control now, but expectations for rising inflation are increasing and could lead the Fed to tighten monetary policy faster. While the economic data released last week was overwhelmingly positive, record-setting consumer confidence, strong housing data and rising home prices could also lead to higher inflation down the road.