Stocks fall on renewed Fed rate hike fears

What counts for most people in investing is not how much they know, but rather how realistically they define what they don’t know. – Warren Buffett

Negative sentiment returned to the stock market last week as both the S&P 500 Index and the Dow Jones Industrial Average fell more than 3% after a mixed jobs report convinced investors that the Federal Reserve would raise interest rates in September. Prior to the employment report on Friday, stocks had been weak as manufacturing data from China suggested that economic growth there was slowing. Investors feared that the slowdown could become contagious and negatively affect growth in the U.S. even though our exports to China account for only 0.7% of our total gross domestic product (GDP). Investors are trading stocks based on fear and emotion and that was evident after the release of the August jobs report as well. The government announced that 173,000 jobs had been created, well below expectations for 220,000 new jobs. But the number of jobs from the previous two months was revised higher and the August unemployment rate fell to 5.1% from 5.3% in July. The labor participation rate, however, is at the lowest level since the late 1970s as many unemployed people have abandoned their job search. But other parts of the employment report were more encouraging as wages rose and more full time workers were added to the payrolls. The August jobs report is also notorious for being unreliable and the jobs number is likely to be revised higher at a later date. With concerns about weakening global growth overseas, particularly in China, and given the recent and ongoing volatility in the stock market, it would seem that Federal Reserve should error on the side of caution and postpone an interest rate hike until later in the year. If, on the other hand, the Fed decides to raise interest rates in September, it could also send a positive message to investors that the economy is strong enough to withstand a token rate hike.

Last Week

The Institute for Supply Management (ISM) manufacturing index fell slightly in July while the ISM services index also slipped but was still better than expected. U.S. construction spending was strong in July as it reached the highest level in more than 7 years, boosted by an increase in houses, factories and power plants. Revised second quarter productivity was strong, helping to keep inflation low, and the U.S. trade deficit in July dropped over 7%, which bodes well for GDP in the third quarter.

The Federal Reserve’s Beige Book, a summary of the economic conditions of the Fed’s twelve districts, indicated that most of the country was experiencing solid growth with the only deterrent being the energy sector.   Inflation was muted but some districts saw wage pressures building due to tighter labor markets.

For the week, the Dow Jones Industrial Average dropped 3.2% to close at 16,102 while the S&P 500 Index slid 3.4% to close at 1,921. The Nasdaq Composite Index fell 3.0% to close at 4,683. 

 This Week

In this holiday-shortened week, there are only a few economic reports due to be released. The producer price index (PPI) is expected to decline slightly as a result of lower wholesale energy prices and the University of Michigan September consumer sentiment index should remain unchanged as consumers remain optimistic about the prospects for jobs and continued economic growth.

After being closed on Thursday and Friday of last week, the Chinese stock market is scheduled to open on Monday and there are a number of economic reports scheduled to be released this week that could give investors a better read on the state of China’s economy, namely trade data and industrial output.

The earnings calendar is sparse again this week as the most notable companies due to report include Men’s Wearhouse, Barnes & Noble, Pep Boys and Kroger.

Portfolio Strategy

The current correction, which places the S&P 500 down 9.8% from its all-time high of 2,130, is probably more the result of technical factors and short-term trading strategies by professional traders, hedge funds and institutions rather than any fundamental reasons. The stock market was long overdue for a sell-off of this magnitude and investors may have become complacent with the S&P 500 Index trading in a relatively narrow range for most of the year. Despite fears of a slowdown in China, uncertainty over the timing of a Fed rate hike and the effects of a strong dollar and plunging oil prices on corporate profits, the fundamentals of the U.S. economy remain strong. Economic growth in the second quarter was at a brisk 3.7% annual pace and the manufacturing sector continues to post readings above 50, indicating expansion. Most economists expect GDP growth to accelerate in the second half of the year, averaging about 2.5% for the year. Private sector job growth has been strong and the unemployment rate has fallen to 5.1%. There has been steady improvement in housing and construction and automobile sales have been near record highs. While the Federal Reserve will most certainly raise interest rates by at least 25 basis points this year, they likely will emphasize that the process will be gradual, maintaining their accommodative stance. Excluding the energy sector, corporate profits also continue to grow and valuations have fallen from historically high levels. Based on estimated S&P profits of about $119 for 2015 and $129 for 2016, the S&P 500 Index now trades at about 16 times this year’s earnings and less than 15 times next year’s earnings. Although caution should be exercised near-term, the backdrop for U.S. equities appears favorable and bodes well for a rebound in stock prices by year-end.