Stocks surge on dovish remarks by Fed Chairman Powell

It’s not always easy to do what’s not popular, but that’s where you make your money. Buy stocks that look bad to less careful investors and hang on until their real value is recognized. – John Neff, American investor and former manager of the Vanguard Windsor Fund

What a difference a week makes. After suffering its worst Thanksgiving week decline since 2011, the stock market came roaring back last week and turned in its best performance in nearly seven years. All three major market averages were up at least 4.8% with the technology-laden Nasdaq Composite Index leading the way with a gain of 5.6%. What fueled the rally in stocks were dovish comments by Federal Reserve Chairman Jerome Powell in a speech at the Economic Club of New York. In stark contrast to comments he made back in early October that the Fed was a long way from a neutral monetary policy, Powell said that the Fed’s benchmark interest rate was “just below” neutral. He also stressed that there is no preset policy path and that stock market valuations were in line with long-term levels with no excesses. Although most observers believe that the Fed will raise the federal funds rate by a quarter of one percent at their meeting this month, any further rate hikes in 2019 will depend on economic data and could be far fewer than originally expected. His comments seemed to ease fears that the Federal Reserve would tighten monetary policy even as economic growth slows next year. There also was optimism that a trade agreement with China would be completed at the G-20 summit meeting over the weekend. There were reports that the U.S. and China were finding common ground on trade ahead of the meeting and that talks were ongoing with China at all levels. President Trump even acknowledged that he was worried about the impact of a trade war with China on the markets and the economy and suggested that he may seek a compromise with China on trade. While the markets were weak during Thanksgiving week, consumer spending was not as Black Friday online sales were a record at $6.22 billion and rose nearly 24% from last year. Cyber Monday sales were also strong, a positive trend heading into December since consumer spending accounts for about 70% of total economic activity.

Last Week

U.S. third quarter gross domestic product (GDP) was unrevised at 3.5%, the same as reported in October, while U.S. consumer spending increased by the most in seven years in October. The core personal consumption expenditures (PCE) index, the Federal Reserve’s preferred measure of inflation, edged up slightly and has risen only 1.8% year-over-year through the end of October. New home sales in October fell more than expected and the September S&P Case-Shiller 20-City Index showed that home prices rose at the slowest pace in nearly two years. U.S. consumer confidence slipped in November from October’s 18-year high but was still strong. This index measures consumers’ assessment of current economic conditions and their outlook for the next six months.

For the week, the Dow Jones Industrial Average jumped 5.2% to close at 25,538 and the S&P 500 Index gained 4.8% to close at 2,760. The Nasdaq Composite Index surged 5.6% to close at 7,330.

This Week

The most important piece of economic data to be released this week will be the November employment report, which is expected to show that about 200,000 new jobs were created and that the unemployment rate remained at 3.7%. October construction spending is expected to show a modest increase while factory orders are expected to fall slightly and be lower than in September. The preliminary December Michigan consumer sentiment index is forecast to be in line with the previous month and still at a very high level.

Among the most prominent companies scheduled to report quarterly earnings this week are Toll Brothers, AutoZone, Dollar General, Kroger, American Eagle Outfitters, Ulta Beauty, H&R Block and Broadcom.

Portfolio Strategy

The plunge in stock prices during the week of Thanksgiving brought equity valuations down to levels that compare favorably with historical norms and are considered reasonable. After last week’s surge in the S&P 500 Index of nearly 5%, equity valuations have risen relative to expected earnings for the balance of this year and 2019. The challenge in determining valuation, which is simply the market price divided by earnings, is estimating the denominator or expected earnings, which analysts often tend to overestimate. The level of earnings depends on many factors and whether or not those factors, either positive or negative, are already priced into the market. Prior to last week, the S&P 500 was trading at 16.5 times expected earnings for 2018 and just 15 times estimated earnings for 2019. Dovish comments from Federal Reserve Chairman Jerome Powell, favorable inflation data from the Fed’s preferred inflation gauge and strong consumer spending results sent stocks soaring last week. After last week’s gains, the S&P 500 Index now trades at 17.2 times 2018 earnings and 15.7 times expected earnings for next year. Although corporate profits are forecast to be much lower in 2019 than the 20% plus earnings growth posted this year, earnings are still expected to increase by about 10%. A truce in the trade war between the U.S. and China and an eventual trade agreement that benefits both sides would lift this uncertainty from the market and could cause stocks to rally even further. At the moment, this favorable outcome does not appear to be priced into the market. But if trade tensions escalate and no deal is made, earnings growth may suffer and valuations may be questioned.