S&P 500 posts gain on earnings, FOMC meeting

Do not save what is left after spending, but spend what is left after saving. – Warren Buffett

The stock market closed modestly higher last week and the S&P 500 Index finished the month of October with a gain of 8% for the best monthly gain in four years, making the correction in August and early September seem like a distant memory. It was the fifth consecutive week that the S&P 500 has posted a gain and puts the benchmark index solidly in the black for the year. Reasons for the rise in stock prices were continued better than expected third quarter corporate earnings reports and an accommodative Federal Reserve that decided to maintain their near zero interest rate policy. With well over half of the companies in the S&P 500 Index having reported earnings, profits have actually risen about 6% and revenue has risen about 1.5% if the energy sector is excluded. Companies in the technology sector have generally posted impressive results and bellwether Apple Computer was no exception last week as it beat both revenue and earnings estimates. In a challenging macro environment characterized by a strong dollar, Fed uncertainty and lackluster global economic growth, earnings so far have exceeded expectations and everyone’s worst fears. Also fueling the stock market’s rise last week was the Federal Open Market Committee (FOMC) decision to leave interest rates unchanged. While the market is having a difficult time making up its mind whether a modest rate hike would be good or bad, it seems to be comfortable with the Fed’s decision for the time being. The Federal Reserve meets again in December and they will decide then if the economic data has been strong enough to warrant a hike in interest rates. They will want to see continued improvement in the labor markets and be confident that inflation is on track to reach their 2% target before pulling the trigger. While the Fed’s statement seemed to suggest a December hike was more probable than before, what is more important is the path of any future interest rate hikes. Given the outlook for modest U.S. economic growth, any sustained increase in interest rates is likely to be very gradual.

Last Week

U.S. new home sales in September fell 11.5%, reaching the lowest level since November 2014, but the drop is likely to be temporary as recent housing data has been strong. U.S. durable goods orders also declined in September with the only bright spot in the report being automobile sales, which rose about 2%. A key measure of business investment called core capital goods orders also posted a modest decline. Weekly jobless claims continued to hover at levels not seen since 1973, suggesting a strengthening labor market.

Gross domestic product (GDP) in the third quarter rose 1.5%, slightly less than expected and far less than the 3.9% growth that was registered in the second quarter. The reason for the weak growth was an inventory glut that should be temporary as consumer spending continues to be strong due to cheaper gasoline prices and firming housing and labor markets. The personal consumption expenditures (PCE) price index, the Fed’s preferred measure of inflation, rose only 1.2% in the third quarter due to lower gas prices and the effects of a strong dollar.

For the week, the Dow Jones Industrial Average edged up 0.1% to close at 17,663 while the S&P 500 Index gained 0.2% to close at 2,079. The Nasdaq Composite Index increased 0.4% to close at 5,053.

This Week

The employment report for October is forecast to show an increase of about 185,000 new jobs while the unemployment rate is expected to remain at 5.1%. Other economic data due to be released include September factory orders and construction spending, with the former expected to decline and the latter expected to post a modest increase. The ISM manufacturing index for October should remain at a reading of 50, indicating continued expansion in the sector.

The earnings calendar will be heavy again this week and the most notable companies scheduled to report include Sysco, Archer Daniels Midland, Walt Disney, Time Warner, Facebook, Qualcomm, Berkshire Hathaway, Duke Energy, Visa and American International Group.

Portfolio Strategy

While the stock market initially fell and then rose after investors had reviewed the policy statement from the Federal Reserve, the reaction from the bond market was different. The yield on the 10-year Treasury ended the week at 2.15%, up from 2.06% at the end of September, resulting in losses for Treasuries in the month of October. Although the rise in the yield was relatively small, the Fed’s omission this time of its reference to global market volatility left many investors convinced that they would raise interest rates at their December meeting. This reaction occurred despite weak third quarter GDP growth as consumer spending was particularly strong, leaving some to believe that this would be enough for the Fed to raise interest rates in December. There are two employment reports (October and November) due to be released before the December meeting and the report on Friday could provide clues as to the Fed’s intentions. A number much higher than 185,000 in new jobs could signal a December liftoff while a number well below it could mean the Fed won’t raise rates until next year. Either way, for fixed income portfolios, investors would be wise to own a diversified and well-balanced mix of bond funds that invest across the credit spectrum with reasonable duration and average maturity characteristics that limit any interest rate risk. Just as fears were overblown for third quarter corporate earnings results, those same fears may not be justified for significantly higher interest rates. Only modest economic growth at home coupled with weak economies overseas would argue for low interest rates for an extended period of time.