Investing is laying out money today to receive more money tomorrow. – Warren Buffett
After closing at a record high on Monday, stocks suffered a three day losing streak in the holiday-shortened week as trading volumes were light and economic data was sparse. The Dow Jones Industrial Average and the S&P 500 Index succumbed to a fear of heights as they both lost a little over 1% for the week. It was difficult to read too much into the modest losses as many players were absent due to the New Year’s Day holiday. Certainly investors could not be faulted for taking some profits after the stock market’s healthy gains in November and December. On balance, the few pieces of economic data that were released last week tended to be more negative than positive. U.S. weekly jobless claims came in higher than expected, consumer confidence came in lower than expected and the S&P/Case-Shiller Index showed that the rate of increase in single family home prices continued to decelerate. This weaker than expected data might have given investors a convenient excuse to lighten their equity holdings. More importantly, investors could be focused in the near term on upcoming fourth quarter earnings reports as well as the European Central Bank (ECB) meeting later this month. Corporate earnings reports and company guidance going forward will provide investors with much-needed direction. Everyone knows that energy sector profits will be weak due to the plunge in oil prices, but exactly how weak and what effect they have on other sector profits remains to be seen. While ECB President Mario Draghi has hinted at implementing a quantitative easing program similar to that of the Federal Reserve, we should find out at their meeting on January 22nd whether or not they really mean business. With European economies dangerously close to falling into recession, the time has come for the ECB to act decisively to avert deflation and increase economic growth.
A look back at 2014 saw the Dow Jones Industrial Average gain 7.5% for the year while the S&P 500 Index rose 11.4%. The yield on the 10-year Treasury fell to 2.17% at year-end after starting the year at 3.03%, providing fixed income investors with attractive total returns and proving once again how difficult it is for economists to forecast the direction of interest rates.
Contributing to the weaker than expected economic data last week were the ISM manufacturing index and construction spending as both came in lower than forecast. A closer look at the jobless claims number reveals that the period between Thanksgiving and January is often volatile and difficult to predict due to the holidays, seasonal hirings and inclement weather. The four-week average of jobless claims helps eliminate the seasonal volatility and is a better predictor of the health of the job market.
For the week, the Dow Jones Industrial Average shed 1.2% to close at 17,832 while the S&P 500 Index fell 1.5% to close at 2,058. The Nasdaq Composite Index dropped 1.7% to close at 4,726.
For the most part, the economic calendar this week is light with the exception of the December employment report due out on Friday. Expectations are for the number of new jobs to be about 225,000 with the unemployment rate remaining at 5.8%. While this jobs total pales by comparison to last month’s nonfarm payroll number of 321,000, it is still considered strong and a sign that the labor market continues to improve. Automobile sales for last month should also be strong and could post the best December in ten years.
The quarterly earnings calendar is also relatively light this week as the most notable companies scheduled to report include Supervalu, Family Dollar Stores, Monsanto, Bed Bath & Beyond and Micron Technology.
With the current yield on the 10-year Treasury below 2.20%, this year promises to be a challenging one for fixed income investors in search of yield. Income-oriented investments such as real estate investment trusts (REITs), electric utilities and high dividend-paying stocks were among the best performers last year but are now trading at rich valuations with much lower yields. The Federal Reserve is also expected to raise the federal funds rate by mid-year and rising interest rates are generally considered bad for bonds. While the possibility exists that bond returns could be negative, the Fed is likely to exercise patience in its approach as a strong dollar, low oil prices and weak economies overseas could help keep interest rates low. Investment grade corporate bonds outperformed Treasuries in 2014 and continue to provide a yield advantage as a double A rated corporate with a 10-year maturity yields about 3%. Falling oil prices have taken their toll on high yield bond prices and yields now are back to levels that compensate investors for the added risk. The best way to invest in this asset class is through the use of funds that are well-diversified and can manage risk effectively. For investors in a high tax bracket, municipal bonds also offer an after-tax yield advantage over Treasuries and usually have higher credit quality than corporate bonds. Despite the problems associated with Detroit’s bankruptcy filing and ongoing financial difficulty in Puerto Rico, default rates for municipal bonds are extremely low as their credit ratings are exemplary. Even Treasuries with their paltry yields can have a place in portfolios as they tend to rise in value when risky investments such as equities fall. As a prudent investor, it’s important to remember that fixed income investments are for safety and stability and to reduce the overall risk of the portfolio. In this low yield environment, income is a secondary consideration.