S&P 500 plunges 5% from record high, rebounds to close modestly higher

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 Schwed Jr., was a professional trader on Wall Street and author

By Friday’s close last week, the Dow Jones Industrial Average and the S&P 500 Index had posted modest gains while the Nasdaq Composite Index ended virtually flat, suggesting that it must have been a rather uneventful week for stocks. But beneath the surface it was anything but as the S&P 500 Index plunged on Monday 5% below its all-time high from September 2^nd on an intraday basis, which was the first 5% pullback since October 2020. The Dow and the Nasdaq suffered similar fates as fear gripped the markets when news spread that China Evergrande Group, China’s largest real estate and land developer, was on the brink of default. Credit analysts believed that the company would miss its $83 million interest payment and saw default as the most likely outcome, sparking fear of spreading financial contagion. Later in the week, though, cooler heads prevailed as the company assured investors that the interest payment would be made on time. There is a greater amount of government control exercised in China and the tools are available to prevent a possible default from turning into a systemic crisis. Meanwhile, the Federal Open Market Committee (FOMC)  also met last week and, as expected, left the federal funds interest rate unchanged near zero and indicated that they expect to begin reducing their monthly bond purchases “soon”. Most observers predict that this means an announcement will be made in November about tapering the $120 billion a month bond-buying program with the taper completed by the middle of next year. The Fed also lowered its economic growth and inflation outlook and said that if economic progress continues as expected, a moderation in the pace of asset purchases would soon be warranted. Interest rate hikes, however, are still in the distant future as long as inflation is transitory as the Federal Reserve claims. Nevertheless, uncertainty with regard to tax increases, government funding, third quarter earnings and Fed monetary policy will all contribute to continued market volatility in the weeks ahead.

Last Week

Housing starts in August were better than expected but builders continued to struggle with shortages of materials and labor. August existing home sales fell as many first-time home buyers were priced out of the market due to tight supply and fewer homes in inventory while new home sales recorded their fourth straight monthly increase and were better than expected. Leading economic indicators in August were better than forecast, suggesting that there should be solid economic growth for the remainder of the year. Weekly jobless claims totaled 351,000, an increase of 16,000 from the prior week and higher than the estimate of 320,000.

For the week, the Dow Jones Industrial Average added 0.6% to close at 34,798 while the S&P 500 Index gained 0.5% to close at 4,455. The Nasdaq Composite Index ended flat to close at 15,047.

This Week

Durable goods orders for August are expected to increase modestly after posting a slight decline in July while the Chicago Purchasing Manager’s Index (PMI) for September is forecast to be above 60, well-above the 50 threshold that indicates expansion. Consumer confidence in September is expected to match the August reading while the final estimate of second quarter GDP should the same at 6.6%.

The most notable companies that are scheduled to report their quarterly earnings this week are Micron Technology, Cintas, CarMax, McCormick and Paychex.

Portfolio Strategy

The market will probably pick up this week where it left off last week with increased volatility despite a lack of potential market-moving economic data and few notable quarterly earnings reports. This week also marks the end of the third quarter at a time when equity valuations are stretched after last week’s rebound and the yield on the 10-year Treasury rose to 1.47% from 1.31% over five days. The Federal Reserve will remain in the spotlight as Fed Chairman Jerome Powell is scheduled to appear before Congress to testify about the pandemic and the monetary policy response to it. A number of Fed officials are also on tap to speak this week and could provide clues about the Fed’s plan to begin tapering its $120 billion a month bond-buying program. They also could shed light on the Fed’s timetable for raising interest rates as more than half of them now believe that it could happen as early as next year. Another hurdle for the market will be a potential government shutdown on October 1^st if Congress cannot pass a funding plan by then. To complicate matters even more, Congress also faces a deadline in raising the debt ceiling. This process could take a while as Congress rarely is able to come to an agreement on anything. Although the Fed will likely continue to be dovish, the fact that it said it would begin reducing its bond purchases “soon” got investor’s attention and bonds sold off. (Bond prices and yields move in opposite directions). Technology stocks and other growth sectors could be particularly vulnerable to rising interest rates as valuations are high relative to their future earnings outlook. With inflation running hotter than anticipated, the personal consumption expenditures (PCE) index, the Fed’s preferred measure of inflation, will be released on Friday and should provide important clues as to whether or not recent high inflation is transitory as the Fed claims. If it comes in higher than expected, the upward trend in bond yields could continue.