Stocks edge higher on earnings, manufacturing data

It would be wonderful if we could avoid the setbacks with timely exits, but nobody has figured out how to predict them. – Peter Lynch

For the fourth consecutive week, the S&P 500 Index posted a gain and in the process set a new record closing high of 2,175 while the Dow Jones Industrial Average closed just shy of its all-time high. With the Brexit vote and the more recent attempted coup in Turkey squarely in the rear view mirror, investors have turned their attention to second quarter corporate earnings and economic data, both of which have been pleasant surprises. While earnings so far have declined about 4% compared to last year, the expected hurdle for earnings has been set low enough that most companies have been able to beat these lowered estimates. For investors, what’s important are earnings relative to expectations rather than absolute earnings or earnings compared to last year’s results. On this basis, the results have been mostly positive.  Last week Goldman Sachs, Morgan Stanley and Bank of America surpassed analyst’s estimates and continued the strong showing by the financial sector. Other blue chip companies such as IBM, General Motors, Microsoft and Qualcomm also posted strong quarterly earnings that were better than expected. Economic data provided an underpinning for stocks, too, as most of the reports last week were favorable. The biggest surprise was in the manufacturing sector as the preliminary U.S. Manufacturing Purchasing Managers Index (PMI) for July was at its highest level since October. Data from the Eurozone in both the manufacturing and services sector was also better than expected and showed signs of strengthening. Both reports seemed to lift investor sentiment here and abroad and provided optimism that economies are getting stronger. For now, the record highs in the stock market have been fueled by low global interest rates, better than expected earnings and continued easy global central bank monetary policies. Stronger economic growth and higher sustainable earnings growth will be needed to support any further gains in stocks.

Last Week

U.S. homebuilder sentiment fell in July as the number of potential buyers dropped. U.S. housing starts rose more than expected in June and existing home sales jumped to their highest level since February 2007 as mortgage rates are at their lowest level since 2013. Jobless claims fell to 253,000, a three-month low, and were much less than the 265,000 that were expected, confirming labor market strength as layoffs have been few and job gains have been solid. Leading economic indicators for June also were better than expected and pointed to moderate economic growth in the U.S. through the end of the year.

The European Central Bank (ECB) met last week and decided to leave interest rates unchanged, although additional stimulus measures could be implemented next month as the effects of the Brexit vote become more clear.

For the week, the Dow Jones Industrial Average gained 0.3% to close at 18,570 while the S&P 500 Index added 0.6% to close at 2,175. The Nasdaq Composite Index jumped 1.4% to close at 5,100.

This Week

New home sales in June are expected to be higher than in May and in keeping with the strong housing data released last week. June durable goods orders are forecast to decline slightly but should be an improvement over the previous month’s report. The advance report on second quarter gross domestic product (GDP) is expected to show a 2.6% growth rate, far better than the 1.1% growth rate reported in the first quarter.

The Federal Open Market Committee (FOMC) holds its two-day meeting and is expected to leave interest rates unchanged, but investors will be looking for clues about the Fed’s future intentions and its view on recent global developments.

This will be the busiest week of the earnings season with McDonald’s, Coca Cola, 3M, Caterpillar, Du Pont, Boeing, Apple, Amazon.com, Facebook, Amgen, Eli Lilly, Merck, Verizon, Ford Motor, Chevron and Exxon Mobil among the most prominent companies scheduled to report.

Portfolio Strategy

News last week that manufacturing data both in the U.S. and Europe showed marked improvement and that leading economic indicators was also stronger than expected was definitely encouraging. Data on the housing market and the labor market have also been solid, leading most economists to increase their GDP growth forecast in the second quarter to at least 2.5%. After posting tepid growth in the first quarter, the economy seems to have found its stride, thanks in part to stronger consumer spending, which accounts for about two-thirds of all GDP. This growing momentum in the economy has greatly reduced the chance of a recession anytime soon, something that investors had feared early in the year. Another fairly reliable indicator of a looming recession is a flat or inverted yield curve. Under normal circumstances, long-term interest rates are higher than short-term interest rates. However, when the yield curve is flat or becomes inverted with short-term rates the same or greater than long-term rates, a recession usually ensues. With the current yield differential between the 10-year Treasury note and the 3-month Treasury bill about 1.25 percentage points, the yield curve is considered normal, making the odds of an imminent recession low.