S&P 500 Index rebounds on strong earnings reports

Risk comes from not knowing what you are doing. – Warren Buffett

The major stock averages rebounded strongly last week on better-than-expected third quarter earnings reports as well as positive economic data both in the U.S. and overseas. Upbeat corporate earnings were just the elixir that the stock market needed to lift it out of the doldrums and regain most of what it had lost in previous weeks. Earlier in the week, disappointing earnings from the likes of IBM, Coca Cola and McDonalds cast some doubt about profits of large multi-national companies since their sales are worth less when converted back into a stronger dollar. But strong earnings from Caterpillar, Microsoft, General Motors and 3M later in the week eliminated these concerns and changed market sentiment for the better. With the earnings season not quite at the halfway mark, about three-fourths of the companies in the S&P 500 Index have beaten earnings estimates while over half have also surpassed revenue projections. Of those companies that have reported their quarterly earnings, profit growth has averaged about 7% on revenue growth of about 5%. These solid earnings reports have been welcome news for the stock market that only the week prior was teetering on the brink of a full-blown 10% correction. Economic data was also encouraging as the index of leading economic indicators was much better than expected and signaled that the good times are likely to continue. There was even positive news from the euro-zone as Germany reported stronger manufacturing data while China’s purchasing managers’ index (PMI) also improved. Although both indicators only rose slightly, the data reassured investors that things were not getting any worse. While geopolitical risks and fears almost always make the headlines, it’s ultimately fundamentals and earnings that drive stock prices.

Last Week

U.S. existing home sales in September rose to their highest level in a year as interest rates remained low and attracted buyers. The consumer price index (CPI) edged up slightly in September and has risen only 1.7% over the last twelve months. Jobless claims last week stayed below 300,000 for the sixth consecutive week as companies have laid off fewer and fewer workers.

In overseas news, China reported that its third quarter GDP rose 7.3%, which was the slowest rate of growth in five years. In the euro-zone, the European Central Bank (ECB) is seriously considering the purchase of corporate bonds as a way to help stimulate their moribund economy and increase inflation.

For the week, the Dow Jones Industrial Average jumped 2.6% to close at 16,805 while the S&P 500 Index rose 4.1% to close at 1,964. The Nasdaq Composite Index added 5.3% to close at 4,483. In overseas markets, the MSCI World Index excluding the U.S gained 2.2%.

This Week

This week marks the official end of the Federal Reserve’s quantitative easing program, although recent comments from St. Louis Fed President James Bullard leaves open the possibility of further stimulus given the economic weakness in Europe and Japan and any slowdown in U.S. growth. Recent economic weakness in Europe has led most market observers to now expect the first rate hike in the fourth quarter of 2015 rather than the second quarter.

The first estimate of third quarter GDP growth will be released and most economists expect growth of 3.0%. Durables goods orders for September are expected to rebound strongly after a weak report last month.

Earnings will continue to be the center of attention as Merck, Pfizer and Amgen will report in the health care sector; Exxon Mobil, ConocoPhillips and Chevron in the energy sector; Du Pont and Praxair in the materials sector; Visa and Starbucks in the consumer cyclical sector and Exelon and Dominion Resources in the utilities sector.

Portfolio Strategy

Weak economic data in Europe coupled with global fears over the spread of Ebola, tensions between Russia and Ukraine and the threat of ISIS have all contributed to weakness in European stocks and concerns over third quarter earnings results. Estimated earnings growth for 2014 has been reduced from 12% at the start of the year to about 6% now. The better-than-expected manufacturing data out of Germany last week along with the possibility of additional stimulus measures from the European Central Bank offer a glimmer of hope that the euro-zone economies may begin to improve. The weak euro should be a major tailwind for European companies as it is making the products that they export much more competitive overseas. Data in the next few months will reflect how these companies are faring with the euro at such low levels. In fact, the estimate for European corporate earnings growth in 2015 is 14%. By most valuation measures, European stocks are cheap relative to the U.S. and average profit margins are below historical levels. Recent global events and geopolitical risks should prove to be transitory while better economic news and increased profits lie ahead. Now is not the time to sell European equities as patience and a longer-term view are required.