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S&P 500 closes at all-time high as investors shrug off inflation fears

An investment operation is one which, upon thorough analysis, promises safety of principal and an adequate return. Operations not meeting these requirements are speculative. – Benjamin Graham

The Federal Reserve-induced stock market sell-off caused by comments by Fed officials that interest rates would rise sooner rather than later due to rising inflation expectations was short-lived as the major stock averages all rebounded strongly last week. The Dow Jones Industrial Average gained more than 1,100 points to turn in its best week since March while the S&P 500 Index closed at an all-time high and the Nasdaq Composite Index settled just below its record high. Despite testimony before the House from Federal Reserve Chairman Jerome Powell that mirrored comments from the previous week, investors chose to view the glass as half full rather than half empty and interpreted his remarks in a more positive way. Powell said that the U.S. economy is growing but faces ongoing threats from the coronavirus pandemic as the pace of vaccinations has slowed and new strains of the virus remain a risk. He also said that the recent spike in inflation will moderate over time and will likely fall back to the Fed’s 2% target by 2022. New York Fed President John Williams in a separate speech reiterated those same remarks by saying that the surge in inflation was due to temporary factors such as supply disruptions at a time when demand is surging as the economy reopens. There were other positive news events last week that also helped boost investor sentiment. A bipartisan group of senators announced a nearly $1 trillion infrastructure plan that should get support from both parties. In its annual stress test of the banking industry, the Federal Reserve also announced that banks could easily withstand a severe recession since their capital levels were “well above” the required minimums. The decision paves the way for banks to raise their dividends and buy back their stock, two things that were suspended during the pandemic. Although the S&P 500 is perched at an all-time high, the risks also appear to be growing, namely the timetable for higher inflation and the potential for tighter monetary policy, the strength of the economic recovery and the uncertainty of market leadership going forward.

Last Week

The personal consumption expenditures (PCE) index in May was slightly less than expected but the core PCE index has risen 3.4% over the last 12 months, almost double the Fed’s target of 2%. Durable goods orders in May rose over 2% after declining in April, the only monthly drop in the last 13 months. Existing home sales in May fell for the 4th straight month but were better than expected as the supply of homes for sale has dwindled. New home sales in May fell to a one-year low and were worse than expected as the price of new homes continued to soar due to high lumber prices and shortages of other raw materials. Weekly jobless claims totaled 411,000, higher than the estimate of 380,000 but less than 418,000 in the previous week.

For the week, the Dow Jones Industrial Average surged 3.4% to close at 34,433 while the S&P 500 Index rose 2.7% to close at 4,280. The Nasdaq Composite Index gained 2.4% to close at 14,360.

This Week

The June employment report is expected to show that 650,000 new jobs were created and that the unemployment rate edged lower to 5.6% from 5.8%. Both May construction spending and factory orders are forecast to post increases and be higher than in April while the June consumer confidence index is also expected to be higher than the previous month but still well below pre-pandemic levels. The Chicago Purchasing Managers’ Index (PMI) for June is forecast to be slightly less than the May reading, which was the highest level in nearly 50 years.

The most prominent companies that are scheduled to report quarterly earnings this week are Bed Bath & Beyond, Constellation Brands, General Mills, Micron Technology, McCormick and Walgreens Boots Alliance.

Portfolio Strategy

The most significant piece of potential market-moving economic data this week will come Friday in the form of the June employment report. Not only will investors be closely watching the number of jobs created, but wages are expected to show a year-over-year increase of nearly 4%, much higher than in May. Such an increase, coupled with the higher than expected core personal consumption expenditures (PCE) index last week, could spark inflation fears. Right now investors seem to be onboard with the Federal Reserve’s forecast that inflation will be transitory and will subside toward 2%, the Fed’s target, by next year. The bond market also seems to agree with the Fed as the yield on the 10-year Treasury has fallen from a closing high of 1.74% on March 31st to 1.54% on Friday. (Bond yields move opposite to price.) The fact that bond yields have behaved and have remained relatively low has enabled equities, particularly technology stocks, to post strong returns in the second quarter. The S&P 500 Index has risen nearly 8% during the quarter while the Dow Jones Industrial Average and the Nasdaq Composite Index have gained over 4%. The big story, though, behind these impressive gains has been corporate earnings as analysts have continued to raise their estimates for the balance of the year. Ultimately, earnings are what drives stock prices and second quarter earnings have been much better than originally forecast. The prospect of faster growth as the economy reopens has resulted in higher earnings revisions, making the valuation of the S&P 500 more reasonable with a price earnings ratio on forward earnings of about 22. While this P/E is still higher than the historical average, interest rates remain at historically low levels and monetary and fiscal policies remain supportive.