S&P 500, Nasdaq Composite hit record highs on continued strong earnings

Speculation is an effort, probably unsuccessful, to turn a little money into a lot. Investment is an effort, which should be successful, to prevent a lot of money from becoming a little. – Fred Schwend Jr., American stock broker turned author and best known for his book, Where Are the Customers’ Yachts?

Both the S&P 500 Index and the Nasdaq Composite Index recorded all-time highs on Friday as Federal Reserve Chairman Jerome Powell made positive comments about the U.S. economy and quarterly corporate earnings continued to be strong. The previous record close for the S&P 500 was way back on January 26^th while the Nasdaq Composite had broken this high in March. In a speech at Jackson Hole, Wyoming on Friday, Powell said that the economy is “strong” and can handle tighter monetary policy in the form of gradual interest rate hikes. He was confident that inflation would remain under control and near its 2% target and expects the Fed to raise rates two more times this year in an effort to normalize monetary policy. The current federal funds rate is in a range of between 1.75% and 2%. In addition to Powell’s favorable remarks about the economy, better than expected earnings provided the necessary fuel to power the market to record highs. In the retail space, Kohl’s, Target and Lowe’s all beat analysts’ revenue and earnings estimates as consumers continued to benefit from recent tax cuts and a strong labor market. Kohl’s raised its profit outlook for the full year while Target reported its best same-store sales growth in 13 years. The minutes from the most recent Federal Reserve meeting also reflected Jerome Powell’s positive comments but acknowledged certain risks that could slow the economy. Fed officials felt that the biggest threat to continued strong economic growth was ongoing global trade tensions and the possibility of a full-blown trade war. They also agreed that stock valuations were “elevated” while corporate borrowing conditions remained “easy”. With no major breakthrough in U.S. and China trade talks that concluded on Friday and no definitive agreement yet on NAFTA, the Fed’s assessment that trade and tariffs pose the biggest risk to the U.S. economy was accurate.

Last Week

U.S. existing home sales in July fell for the fourth straight month while new home sales fell to a 9-month low. Lack of supply was the biggest reason for the decline as a shortage of properties for sale on the market pushed up home prices beyond the reach of potential buyers. Durable goods orders in July fell more than expected but core capital goods (non-defense capital goods that excludes aircraft) were much better than forecast and a good indicator of business equipment spending plans. Weekly jobless claims fell by 2,000 to 210,000 and were less than expected as the labor market remains strong with very few layoffs.

The strength in the stock market last week was also helped by merger and acquisition activity as PepsiCo agreed to buy SodaStream for $3.2 billion and Tyson Foods agreed to buy Keystone Foods for $2.16 billion.

For the week, the Dow Jones Industrial Average rose 0.5% to close at 25,790 and the S&P 500 Index gained 0.9% to close at 2,874, a record high. The Nasdaq Composite Index jumped 1.7% to close at 7,945, also a record high.

This Week

The second reading of second quarter gross domestic product (GDP) is expected to confirm growth of 4.1% and the ISM Chicago Purchasing Manager’s Index (PMI) for August is expected to fall slightly but still remain comfortably above 60, an indication of strong expansion. Both the August consumer confidence index and the Michigan consumer sentiment index are forecast to remain at high levels. The Federal Reserve’s preferred measure of inflation, the personal consumption expenditures (PCE) index, is expected to increase 2.3% year over year while the core rate that excludes food and energy is expected to rise 2%, in line with the Fed’s target rate of inflation.

Among the most notable companies scheduled to report earnings this week are Dollar General, Dollar Tree, Dick’s Sporting Goods, Best Buy, Tiffany, H&R Block, Eaton Vance and Campbell Soup.

Portfolio Strategy

Last week Federal Reserve Chairman Jerome Powell commented that inflation remains under control and this week he’ll find out whether or not this is true. The Fed’s preferred inflation gauge, the core PCE index, will be released and it is expected to increase slightly to 2% in July from 1.9% in June. Inflation has been noticeably absent during this economic recovery, owing mainly to increased use of technology and automation, the Internet, global competition and sluggish wage growth. Although the unemployment rate has fallen to a 20-year low of 3.9%, wage growth has been less than 3% a year. Even though inflation is relatively benign, the Fed maintains that it plans to gradually raise interest rates with a rate hike all but certain in September and another one more than likely in December. The forecast for 2019 is much more uncertain with the Fed figuring at least three additional rate hikes and the market pricing in only one. Concerns have also risen about the flattening of the yield curve or the difference between the 2-year Treasury yield and the 10-year Treasury yield. Last week that difference shrunk to only 19 basis points (a basis point is one hundredth of one percent) as the 10-year yielded 2.82% and the 2-year yielded 2.63%, the narrowest the gap has been since 2007. The short end of the curve has risen as the Federal Reserve has increased the federal funds rate while the long end of the curve has been held down by low global interest rates, Turkey’s currency crisis and emerging market weakness as investors view the U.S. as a safe haven. Since an inverted yield curve (short rates higher than long rates) can lead to a recession, this relationship bears watching. As John Templeton once said, the four most dangerous words in investments are “This time it’s different.” Many people are saying this now about the flattening yield curve but history has a way of repeating itself.