Fed policy uncertainty causes stocks to decline

While some might mistakenly consider value investing a mechanical tool for identifying bargains, it is actually a comprehensive investment philosophy that emphasizes the need to perform in-depth fundamental analysis, pursue long-term investment results, limit risk and resist crowd psychology. – Seth Klarman

The major stock averages all declined last week as the Federal Reserve’s Sept 17^th decision to leave interest rates unchanged seemed to create more questions than answers about the timing of an eventual rate hike. In hindsight, stocks probably would have preferred that the Fed raise the federal funds rate by 25 basis points and proclaim that there would be no additional rate increases for a while or that the tightening process would be very gradual. The fact that the Fed’s policy statement cited slowing growth in China and weak global economies as additional reasons for not pulling the trigger only added to the uncertainty. Investors were justified in questioning whether or not the U.S. economy would be affected by this slowdown overseas as corporate profits might be at risk. In an attempt to clarify their message last week, Fed Chair Janet Yellen and other Fed members seemed to make matters worse. St. Louis Federal Reserve President James Bullard said that there is a powerful case to be made for raising interest rates while Atlanta Fed President Dennis Lockhart expressed confidence that there would be a rate hike by year-end. In a speech on Thursday at the University of Massachusetts, Janet Yellen emphasized that prospects for the U.S. economy are generally solid and downplayed the risks of a slowdown in China. She stressed that the Fed’s goal is to normalize monetary policy over the near-term and signaled that, in all likelihood, interest rates would be raised this year. It’s hard to believe that the economy will be much different in December than it has been in September, but apparently that is the month targeted for a rate liftoff. Right now, investors need clarity on both the timing of an interest rate hike and China’s growth in order to make investment decisions. Until they get answers to these questions, the stock market is likely to remain volatile as trading will be based on worry and fear.

Last Week

U.S. existing home sales fell more than expected in August as rising home prices might have shut out potential buyers. August new home sales, though, rose almost 6%. Durable goods orders dropped in August for the first time since May and core capital goods orders, a key measure of business investment, also fell. Second quarter gross domestic product (GDP) was revised upward to 3.9% from 3.7% on stronger consumer and construction spending. This is a good sign as consumer spending accounts for more than two thirds of U.S. economic activity.

While corporate earnings reports last week took a back seat to global growth concerns, the results were generally better than analysts had expected. Nike reported strong revenue and earnings growth with 30% sales gains in China, easing concern of slowing growth in that country. Caterpillar, however, announced that it plans to cut as many as 10,000 jobs as demand for its equipment remains weak from mining and energy companies.

For the week, the Dow Jones Industrial Average declined 0.4% to close at 16,314 while the S&P 500 Index fell 1.4% to close at 1,931. The Nasdaq Composite Index lost 3% to close at 4,686.

This Week

The most important piece of economic data to be reported this week will come on Friday as the government releases the employment report for September. Expectations are for 210,000 jobs to be created after a disappointing number in August and for the unemployment rate to remain at 5.1%. Other economic data include the September Chicago purchasing managers index (PMI), which should confirm continued expansion with a reading above 50, and August construction spending, which is forecast to show a healthy increase.

Fed Chair Janet Yellen as well as several other Fed officials are scheduled to make remarks or give speeches this week that will undoubtedly attempt to provide clarity to the Fed’s message but will probably only serve to add to the uncertainty over the timing of an interest rate hike.

In an unusually light week for corporate earnings reports this week, the most notable companies due to report are Costco Wholesale, McCormick & Co. and Micron Technology.

Portfolio Strategy

During the past two years, value stocks, or those considered undervalued or cheap based on below average price earnings ratios and above average dividend yields and dividend growth prospects, have underperformed growth stocks. Growth stocks typically do well during periods of modest economic growth as investors place a premium on their ability to still expand their business and grow their earnings. These stocks generally have above average price earnings ratios and below average dividend yields as earnings are reinvested back in the business to generate future growth rather than paid out to shareholders as dividends. Since the S&P 500 bottomed on August 25^th during the recent correction, growth stocks have again outperformed value stocks. The outperformance of growth stocks might come to an end, however, as most economists are forecasting stronger economic growth in the months ahead, a situation that could benefit value stocks as a rising tide could lift all boats. The labor market is strong, the housing market is improving, manufacturing is expanding and low oil prices could boost consumer spending. If investors are convinced that the recent correction has run its course, then they should be more inclined to buy the cheapest stocks, which, by definition, are the so-called value stocks. These are the stocks that could outperform in the months ahead.