Strong GDP growth lifts stocks to record highs

In this business if you’re good, you’re right six times out of ten. You’re never going to be right nine times out of ten. – Peter Lynch

Stocks continued their positive momentum in the holiday-shortened week as the Dow Jones Industrial Average eclipsed the 18,000 level for the first time ever and remained solidly above that threshold at week’s end. The S&P 500 Index also closed at an all-time high, its 52^nd record close of the year. Santa Claus obviously did his job in spreading holiday cheer but the economic data also contributed to the strength in stock prices. In the aftermath of the Federal Reserve’s conciliatory comments with regard to being patient in raising interest rates, the government announced that the final GDP for the third quarter was 5.0%, the fastest pace of economic growth since the third quarter of 2003 and up substantially from the previous estimate of 3.9%. The primary reason for the strong growth was consumer spending as low gasoline prices, improved jobs data and better wage prospects all helped fuel the increased spending. This was the most important piece of economic data released last week and shows that low oil prices should provide more of a positive catalyst for the U.S. economy than a negative one. More investors are coming to the realization that cheap gasoline prices are like a tax cut from the government and should provide a powerful tailwind for the economy. While weak oil prices and low interest rates can be construed as a sign of a slowing economy, no one is predicting that 5% GDP growth is sustainable, either. But strong economic growth since the first quarter has raised confidence that GDP could grow 3% next year. Under this scenario and with no recession on the horizon, the stock market should continue to provide modest gains, although recent strength in the market may have borrowed from next year’s returns.

Last Week

In addition to the positive GDP reading for the third quarter, U.S. consumer sentiment rose to its highest level since 2007 on cheaper gasoline prices and better job and wage prospects in the future. Other economic data released last week was somewhat disappointing. Sales of existing homes slowed to the weakest pace in six months and new home sales also fell as the housing recovery continues to sputter. Durable goods orders also fell in November as an expected boost from Boeing airplane orders failed to materialize.

Faced with its worst economic crisis since 1998, Russia could lose its investment-grade credit rating as low oil prices, a weak currency and sanctions have crippled its economy. Saudi Arabia remains adamant that it won’t cut oil production even as prices fall but sources within the country see oil climbing to $80 a barrel at the end of next year.

For the week, the Dow Jones Industrial Average rose 1.4% to close at 18,053 while the S&P 500 Index added 0.9% to close at 2,088. The Nasdaq Composite Index also gained 0.9% to close at 4,806.

This Week

This week promises to be another quiet one as the markets in the U.S. and elsewhere around the world are closed on New Year’s Day. The consumer confidence index could see a sizable jump due to the positive effects of lower gasoline prices, higher incomes, more job gains and the wealth effect of a higher stock market. Housing data should be favorable as the S&P/Case-Shiller Index of home prices is expected to rise 4% year over year in October and pending existing home sales in November are forecast to increase 0.5%.

There are no quarterly earnings reports on the calendar this week but Walgreen shareholders will vote on the merger with Alliance Boots, a European company.

Portfolio Strategy

With 2014 drawing to a close, a look back reveals some unexpected factors and surprising events that helped shape stock and bond market returns. Chief among them has been the decline in interest rates as the 10-year Treasury has fallen to 2.2% from 3.0% at the start of the year, providing a 10% return. Most economists had expected this benchmark yield to rise to 4% by year-end. Another unanticipated event has been the acceleration in GDP and the strength of the U.S. economy in the face of weak European growth, slowing growth in China and an outright recession in Japan. The fact that the U.S. was able to decouple from developed economies overseas propelled the dollar higher.  The strong dollar was like a magnet that attracted foreign capital to U.S. stocks and bonds, boosting their returns. Compared to yields of less than 1% in Germany and Japan, Treasury yields looked downright attractive. The unforeseen bond rally also helped the performance of interest-rate sensitive sectors such as utilities, which have been one of the top-performing groups this year. The best-performing sector has been health care, which is also considered a defensive group. Probably the biggest surprise during the year was the magnitude and speed with which the price of oil has fallen, from a $107 a barrel as recently as this summer to about $55 now, a drop of almost 50%. As a result of this decline, it’s not surprising that the energy sector has been the worst performing sector in the S&P 500. What is surprising is that the energy sector was the best-performing group in the second quarter and the second best-performing sector in the first half of the year. It’s safe to say that the swiftness of the oil price decline caught many investors off-guard.