S&P 500 posts small gain as focus turns to Fed

Don’t invest in anything that you don’t understand. Do your research first. – Paul Clitheroe

In a rather quiet week characterized by low volatility, a lack of potential market-moving economic data and earnings reports dominated by retailers, the major averages closed basically flat ahead of the Memorial Day holiday weekend. After setting new all-time highs earlier in the week, both the Dow Jones Industrial Average and the S&P 500 Index traded lower, with the DJIA posting a modest loss for the week and the S&P 500 registering a small gain. With a dearth of important economic data and earnings season virtually over, investors turned their attention once again to the Federal Reserve and Fed Chair Janet Yellen for clues on the timing of the first interest rate hike. The minutes from the Federal Open Market Committee (FOMC) meeting in April suggested that a rate hike is “unlikely” in June and nothing in the minutes suggested that interest rates would be raised anytime soon. This implies that either September or December is the most likely month for the first rate hike to occur. In a speech on Friday, Janet Yellen reiterated these points by saying that monetary policy remains dependent on economic data and that an interest rate hike would be appropriate only if the economy improves. She fully expects the U.S. economy to rebound by posting moderate growth this year with the unemployment rate falling to 5% by year-end. This stronger growth should also increase the inflation rate closer to the Fed’s target of 2%. This would put the Fed on track to raise short-term interest rates later this year. Since nothing new was gleaned from either the Fed minutes or Janet Yellen’s remarks, investors will also have to rely on the economic data, deciding whether or not it’s strong enough to warrant an increase in interest rates but knowing that June has likely been taken off the table.

Last Week

Housing data released last week was again mixed as U.S. housing starts and permits in April soared while sales of existing homes fell by over 3%. A survey of the National Association of Home Builders (NAHB) also showed that builders are less optimistic and confident about the future. In a hopeful sign for the economy, the index of leading economic indicators rose a healthy 0.7% in April. The consumer price index (CPI)) for April edged up 0.1% while the core rate, which excludes the often-volatile food and energy components, rose 0.3% on higher housing and medical care costs. Over the past twelve months, the core CPI has risen 1.8%, just below the Fed’s target rate of 2%.

Both Home Depot and Target reported better-than-expected quarterly earnings and sales and Target raised its earnings guidance for the year. In other corporate news, five of the world’s biggest banks (JP Morgan Chase, Citigroup, Barclays, Royal Bank of Scotland and UBS) pleaded guilty to manipulating currencies and will pay $5.6 billion in fines.

For the week, the Dow Jones Industrial Average fell 0.2% to close at 18,232 while the S&P 500 Index added 0.2% to close at 2,126. The Nasdaq Composite Index rose 0.8% to close at 5,089.

This Week

Durable goods orders for April are expected to rise modestly while April new home sales should increase to an annual pace of about 509,000 in the month. First quarter gross domestic product (GDP), which rose an anemic 0.2%, will likely be revised lower and show that the economy actually contracted. Consensus estimates call for a reading of -0.7% caused by a wider March trade deficit and lower inventories. If this downward revision occurs, it will support the widespread belief that a June interest rate hike is not in the cards.

Among the more prominent companies scheduled to report quarterly earnings this week are Autozone, Toll Brothers, Tiffany & Co., Abercrombie & Fitch and Costco Wholesale.

Portfolio Strategy

With the earnings season largely in the rear view mirror, there are several important keys for the stock market as we head into the seasonally slow summer months. After very weak GDP growth in the first quarter that will likely be revised to show the economy contracted, growth must rebound in the next several quarters in order to drive corporate earnings higher. Although the energy sector was mostly responsible for sluggish year over year S&P 500 earnings growth of just 2% in the first quarter, stable oil prices along with a stable dollar should help provide a favorable backdrop for higher profits. The Federal Reserve will also play a significant role in determining the near-term direction of the stock market. For the moment, it appears that September is the earliest possible month for an interest rate hike, with one most definitely occurring sometime in the fourth quarter. An earlier or larger than anticipated hike in rates would likely cause stocks to sell off. After the initial shock, though, the stock market would probably recover on the assumption that the reason for a rise in rates is a stronger, more vibrant economy. Finally, the general level of interest rates in the bond market and how fast those rates rise will affect the performance of stocks. Provided that interest rates rise gradually on the belief that higher economic growth expectations will translate into higher corporate profits, stocks should continue to do well. However, if rates move abruptly higher, the stock market is likely to pull back. In a perfect world, the best scenario for stocks would be for stable or gradually rising interest rates based on favorable economic growth prospects. With stocks already priced for perfection, there is little margin for error.