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Stocks post gains despite more troubling inflation data

The key to investing is not assessing how much an industry is going to affect society, or how much it will grow, but rather determining the competitive advantage of any given company and, above all, the durability of that advantage. – Warren Buffett

In a positive week for the stock market, the Dow Jones Industrial Average celebrated its 125-year anniversary by gaining nearly 1% and the S&P 500 Index snapped its two-week losing streak by gaining over 1%. The technology-laden Nasdaq Composite Index outdid them both, though, with an increase of 2% as investors gravitated back to more growth-oriented stocks that trade at higher multiples. Despite a stock market that is historically expensive with the S&P 500 Index priced at about 22 times forward earnings, stocks continue to grind higher and defy skeptics that claim that a sizable correction is just around the corner. Since last week’s stock market action was characterized by low volatility and low trading volume ahead of the long Memorial Day weekend, it’s difficult to read too much into the gains as the market seems to be struggling for direction and in a holding pattern until there is more clarity on the outlook for inflation and the Federal Reserve’s monetary policy. Investors have adopted a ‘buy the dip’ mentality where stocks are purchased on any kind of weakness, thereby preventing any sizable correction. While recent inflation data has been troubling, the core personal consumption expenditures (PCE) index, the Fed’s preferred inflation measure, did not alleviate those concerns as it was higher than expected but less than many had feared. The PCE index is considered by the Fed to be a wider-ranging measure of inflation and has a broader scope than the Labor Department’s consumer price index. A 3.1% year-over-year increase in April, though higher than the Fed’s target of 2%, was only slightly above expectations and enabled investors to breathe a sigh of relief for the time being.  Investors also received good news about the virus as the average daily Covid-19 cases fell below 25,000 as nearly half of the U.S. population has now received at least one vaccination dose. This positive trend should lead to a stronger economic recovery with continued higher corporate earnings and an accommodative Federal Reserve, both of which should provide a favorable backdrop for equities.

Last Week

U.S. durable goods orders fell more than expected in April and declined for the first time in 11 months as a shortage of computer chips used in the manufacture of automobiles was the primary reason for the drop. But orders for nondefense capital goods excluding aircraft, a measure of business investment, showed a strong increase, even though supply chain constraints remain a headwind. The revised estimate of first quarter GDP was left unchanged at 6.4% and weekly jobless claims fell to 406,000, much less than forecast, and a new pandemic low. Both the consumer confidence index and the University of Michigan consumer sentiment index came in slightly below estimates in May as optimism over jobs was offset by concerns over rising inflation.

For the week, the Dow Jones Industrial Average rose 0.9% to close at 34,529 while the S&P 500 Index gained 1.2% to close at 4,204. The Nasdaq Composite Index jumped 2.1% to close at 13,748.

This Week

The employment report for May is expected to show that 700,000 new jobs were created and that the unemployment rate fell to 5.9% from 6.1%. The Institute for Supply Management (ISM) manufacturing and services sector indexes for May are both forecast to be above 60, comfortably in expansion territory. Construction spending is also expected to increase in April and remain just below its all-time high recorded back in January of this year.

The Federal Reserve releases its beige book, a collection of data from each of the Fed’s twelve districts that gauges the health of the overall economy.

Among the most notable companies scheduled to report quarterly earnings this week are Broadcom, CrowdStrike, DocuSign, Hewlett Packard Enterprise, NetApp, Zoom Video Communications, Advance Auto Parts, J.M. Smucker and Lululemon Athletica.

Portfolio Strategy

The most important piece of economic data this week is the May employment report, with nonfarm payrolls expected to rebound strongly after last month’s disappointing 266,000 new jobs, far short of the 1 million jobs that were forecast. Another weak jobs report could make investors nervous that the economic recovery is sputtering. In addition, June is historically not a strong month for the stock market and is tied with September for being the worst month of the year. Although the core personal consumption expenditures (PCE) index was higher than forecast, expectations were far worse after the surge in the consumer price index. The biggest risk to the market appears to be the inflation outlook, which could impact interest rates and bond yields. The Federal Reserve has maintained an easy monetary policy as the economy recovers from the pandemic and insists that the rise in inflation is strictly temporary since the data is being compared with a weak period last year. Despite the higher inflation, the yield on the 10-year Treasury has remained in a fairly tight range and ended Friday at only 1.58%.  If inflation does heat up and appears more permanent, the Fed could begin to reduce its monthly bond purchases and raise interest rates. Higher rates would mean higher costs for companies and could entice investors to choose higher-yielding bonds over stocks. Higher interest rates also make growth-oriented stocks with higher price earnings ratios less attractive to investors. For these reasons, investors should favor value-oriented stocks and more cyclical sectors of the market, which have outperformed their growth counterparts and should continue to post higher returns. Despite their outperformance this year, value stocks in sectors such as industrials, financials, energy and materials are still cheaper and should continue to benefit from a stronger economy.