S&P 500 rebounds on dovish comments by Fed

Twenty years in this business convinces me that any normal person using the customary three percent of the brain can pick stocks just as well, if not better, than the average Wall Street expert. – Peter Lynch

Dovish comments by Federal Reserve Chair Janet Yellen last week provided the impetus for stocks to resume their upward trend as the S&P 500 Index rose nearly 2%. After plunging more than 10% earlier in the year, the S&P 500 rebounded strongly in March with a gain of 6.6% to post a return of 0.8% for the first quarter. The Dow Jones Industrial Average staged its biggest quarterly reversal since 1933 and also ended the quarter on a positive note. Some of the credit for this turnaround should be given to the Fed and Janet Yellen, who said last week at the Economic Club in New York that the Fed should proceed “cautiously” with regard to monetary policy given global risks to growth. In other words, slowing economic growth and mixed data on the U.S. economy mean that only gradual increases in the fed funds rate are warranted, implying no rate increase later this month when the Federal Reserve meets. Janet Yellen also conceded that overall inflation for this year will likely be less than the Fed’s 2% objective, another reason why the number of forecasted interest rate hikes in 2016 has been cut in half. Stocks also received a boost from the employment report in March as the U.S. added a better-than-expected 215,000 new jobs, even as the unemployment rate edged up to 5% from 4.9%. This slight increase was due to more people entering the labor force, a positive sign as the labor participation rate increased to 63%, the highest level in two years. Weakness in the dollar provided another solid underpinning for equities as U.S. multi-national companies are more competitive in overseas markets and able to reap higher profits. The biggest surprise last week was that stocks closed higher despite the fact that oil prices fell 7% to $36.80 a barrel. In prior weeks, there had been a positive correlation between the price of oil and the direction of the stock market. The fact that the two decoupled should be taken as a positive sign that oil prices may have stabilized and that the worst of the decline may be over.

Last Week

With regard to the housing sector, pending home sales rose 3.5% in February, better than expected, as mortgage rates dipped to the lowest level in almost a year. Home prices rose 5.7% in January according to the S&P/Case-Shiller Composite Index as the inventory of homes for sale remains low. Manufacturing data was also strong last week as the Chicago purchasing managers index (PMI) recorded a healthy increase and the Institute for Supply Management (ISM) manufacturing index beat expectations. Both consumer confidence surveys released last week met or exceeded estimates.

For the week, the Dow Jones Industrial Average added 1.6% to close at 17,792 while the S&P 500 Index gained 1.8% to close at 2,072. The Nasdaq Composite Index jumped 3% to close at 4,914.

This Week

There is a dearth of economic data this week with February factory orders, expected to decline slightly, and the March ISM non-manufacturing index being the most important pieces of data. Reports on February international trade, consumer credit and wholesale inventories will also be released. Investors will again look for clues on any changes in Federal Reserve monetary policy when the minutes are released from the last Fed meeting.

Fed Chair Janet Yellen joins former Fed chiefs Ben Bernanke, Alan Greenspan and Paul Volcker in a panel discussion while European Central Bank (ECB) President Mario Draghi makes a presentation about Europe’s economic and financial situation.

Among the most notable companies on this week’s earnings calendar are Walgreen, Monsanto, Bed Bath & Beyond, CarMax, Constellation Brands, Darden Restaurants and ConAgra Foods.

Portfolio Strategy

Cautious remarks by Fed Chair Janet Yellen last week about the fragile state of the global economy imply that low interest rates are here to stay for the foreseeable future. The yield on the 10-year Treasury began the year at 2.23% but has fallen to 1.79% as of Friday as GDP estimates for the first quarter have tumbled and inflation remains benign. Developed market economies in Europe and Japan are also experiencing sluggish growth and their central banks have implemented negative interest rates and other stimulus measures to reignite growth. While the March jobs report exceeded expectations and the labor market continues to be strong, notably absent from recent employment data has been any sign of wage inflation. In fact, wages rose modestly in March and have risen only 2.3% over the past year. This lack of wage inflation is partially responsible for the Fed’s decision to reduce its interest rate hike forecast and why the federal funds futures market assigns only a one in three chance of a 25 basis point rate hike by June. Many investment strategists believe that the Fed will forego another interest rate hike until the second half of the year. With interest rates mired near historical lows, income-seeking investors might be tempted to reach for yield but should be aware of the risks involved in doing so. High yield or junk bonds may look enticing with their outsized yields, but many of these securities are troubled energy-related names with excessive debt and weak balance sheets that could be teetering on the brink of default.  Investors should not take risks with the fixed income portion of their portfolios but, instead, focus on investment-grade corporate bonds with a yield advantage over Treasuries or high quality municipal bonds for those investors in higher tax-brackets. In the event that economic fundamentals do not improve and market volatility returns, a solid fixed income portfolio serves as a ballast by protecting principal in down markets and reducing a portfolio’s overall risk.