Stocks slide on interest rate fears

I believe that thrift is essential to well-ordered living and that economy is a prime request of a sound financial structure, whether in government, business or personal affairs. – John D. Rockefeller, Jr.

Despite strong economic data and generally positive corporate earnings reports last week, the Dow Jones Industrial Average suffered its worst weekly loss since January as investors fretted over the future course of Federal Reserve monetary policy. In many ways, good news was perceived as bad for both stocks and bonds. This conundrum was particularly evident in the second quarter GDP number, which rose a much better-than expected 4% after contracting by a revised 2.1% in the first quarter. The surprising growth was widespread as consumer spending, business investment and government spending all increased. The report also showed that the price index jumped over 2%, the fastest pace in three years. Even the Federal Reserve expressed optimism about the economic recovery after its two-day policy meeting. It acknowledged that the economy was improving and that the risks of deflation were subsiding. It also reduced the monthly bond-buying program by another $10 billion and said that the program will likely end in October. While this program was designed to suppress interest rates, the Fed nevertheless assured investors that short-term interest rates would remain low for a “considerable time”. But the definition of considerable is vague and open to interpretation. With inflation approaching the Fed’s long-term objective and the labor market showing steady improvement, stronger economic growth as evidenced last week can only lead to higher interest rates, which are perceived as bad for both stocks and bonds. Investors sensed that this rise in rates may happen sooner rather than later and decided to sell stocks. Investors hate uncertainty and right now they are uncertain about the timing and magnitude of any future interest rate hikes.

Last Week

Consumers were also feeling more optimistic about improving economic growth and better job prospects as the consumer confidence index rose to its highest level since October 2007. The employment report for July was also encouraging as there were 209,000 jobs created, the sixth straight month of more than 200,000 new jobs. Average job growth for the first seven months of the year has been 230,000. Hiring was particularly strong among professional ranks, construction and manufacturing, all sectors that have above average salaries. The unemployment rate ticked up to 6.2% as more people entered the labor force in search of work.

In addition to a fear of higher interest rates, two other events last week may have unnerved investors. The U.S. and the European Union imposed more stringent sanctions on Russia over its policies in Ukraine, adding to geopolitical tensions. Argentina defaulted on its bond payments after it failed to agree on a debt restructuring plan with its creditors.

For the week, the Dow Jones Industrial Average fell 2.75% to close at 16,493 while the S&P 500 Index lost 2.69% to close at 1,925. The Nasdaq Composite Index dropped 2.18% to close at 4,352.

This Week

Compared to last week, the economic calendar this week is fairly light. Factory orders for June are expected to show a sizable increase over the previous month and the July ISM nonmanufacturing index should show continued strength. While no changes are expected when the Bank of Japan and the European Central Bank meet to discuss monetary policy, the tone and wording of their releases may shed light on future policy moves.

Among the more prominent companies that report earnings this week are Emerson Electric, American International Group, Walt Disney, Archer Daniels Midland, Time Warner, Viacom, Duke Energy and Devon Energy.

Portfolio Strategy

With the plunge in the stock market on Thursday and the fact that the Dow Jones Industrial Average lost 2.75% for the week, there is talk that maybe this is the start of a much-anticipated correction. The Dow is now actually back in negative territory for the year. While fears over future Federal Reserve monetary policy and the prospect of higher interest rates helped cause the sell-off in stocks last week, past history shows that most corrections of 10% or more occur because of recession fears or actual economic contraction. It’s been over two years since the stock market experienced a correction of any magnitude, although there have certainly been plenty of geopolitical events and other risks that may have caused one. With mostly positive second quarter corporate earnings reports and a strong second quarter GDP number of 4%, a major correction does not seem plausible in light of all of the recent economic data. Most companies have beaten analyst earnings estimates and average earnings growth has handily exceeded expectations. While certain sectors of the market may be overvalued, the overall market is trading at about 17 times earnings, which is the median price-earnings ratio over the last thirty years. A correction cannot be ruled out, but economic fundamentals and earnings suggest it should be fairly mild.