Stocks post modest gains on positive earnings reports

It takes twenty years to build a reputation and five minutes to ruin it. – Warren Buffett

The S&P 500 Index snapped a two-week losing streak with a modest gain as investors sifted through a plethora of quarterly earnings reports and economic data. The Nasdaq Composite Index posted the biggest gain of the major stock averages, rising 1% on the strength of Microsoft’s earnings which easily beat estimates. Other notable companies that reported better than expected earnings last week included Abbott Labs, Morgan Stanley, Bank of America, Verizon, Intel and General Electric, although Intel offered weak guidance for the current quarter and GE missed on its revenue target. So far, of the S&P 500 companies that have reported earnings, nearly 80% of them have beaten Wall Street estimates. While the earnings season still has a long way to go, the results to this point have been encouraging and bode well for the remaining profit reports. If there has been a weakness in the quarterly reports, it’s been on the revenue side as companies seem to be having a difficult time generating top-line growth. A stronger dollar last week curbed some of the enthusiasm for stocks as many multi-national companies derive a large portion of their revenue overseas. The reason for the dollar’s strength has been the widely held belief that the Federal Reserve will raise interest rates at their meeting in December. The odds of such an increase are now greater than 60%. The price of oil also rose last week and briefly touched a 15-month high of $51.60 a barrel before falling back on profit-taking. The Energy Information Administration (EIA) reported a large drawdown in crude oil supplies and other nations seem to be on board with OPEC’s decision to reduce output. The increase in the price of oil helped stocks in the energy sector, but the overall market is likely to mark time until the presidential election is over and there is more clarity on the results of the third quarter earnings season and a Fed rate hike in December.

Last Week

Economic data was mixed again last week and sent conflicting signals over the strength of the U.S. economy. The consumer price index (CPI) rose 0.3% in September, in line with expectations, and has risen 1.5% in the 12 months through September. Overall housing starts were lower than expected last month as single-family starts surged while multi-family units plunged. September existing home sales, on the other hand, hit their highest level since June.  Leading economic indicators in September increased slightly while weekly jobless claims rose by 13,000 to 260,000, but the pace of layoffs still remains very low. Finally, the Fed’s Beige Book showed that most Federal Reserve districts reported modest or moderate economic growth and only mild inflation.

As expected, the European Central Bank (ECB) decided to keep interest rates unchanged but questions remain about the ECB’s desire to extend quantitative easing given Europe’s high unemployment, weak growth and low inflation.

In merger news, Qualcomm and NXP Semiconductors agreed on a $110 a share deal while British American Tobacco agreed to buy the remaining 58% of Reynolds American that it does not already own. AT&T is also in advanced talks to buy Time Warner for more than $80 billion.

For the week, the Dow Jones Industrial Average edged up 0.04% to close at 18,145 while the S&P 500 Index rose 0.4% to close at 2,141. The Nasdaq Composite Index jumped 1.0% to close at 5,257.

This Week

This will be a light week for economic data. The preliminary estimate for third quarter gross domestic product (GDP) is 2.6%, which would be a significant improvement over the second quarter number of 1.4%. September new home sales are expected to be in line with last month’s sales while durable goods orders in September are forecast to increase slightly.

Quarterly earnings reports will more than make up for the shortage of economic data as this promises to be the busiest week of the earnings season. Among the most prominent companies on the agenda are Procter & Gamble, Coca-Cola, Merck, Amgen, Eli Lilly, Bristol-Myers Squibb, General Motors, Ford Motor, 3M, AT&T, Visa, Amazon.com, United Parcel Service, Exxon Mobil, Chevron, Boeing, Caterpillar, Dow Chemical and Du Pont.

Portfolio Strategy

With the increased odds of a Fed rate hike in December, interest rates have begun to rise across all maturities. The yield on the 10-year Treasury ended last week at 1.74%, an increase of 28% from a record low of 1.36% in early July. As interest rates rise, the value of bonds and bond funds fall and the most damage has been done to the long end of the yield curve as well as interest-rate sensitive sectors such as utilities and real estate investment trusts or REITs. While the yield on the 10-year Treasury could rise to 2% early next year, it is unlikely to rise much further as a December rate hike has mostly been priced into the market already. Interest rates should also remain low since economic growth and consumer spending have slowed while job growth has weakened and inflation remains low. It’s true that the European Central Bank (ECB) and the Bank of Japan (BOJ) have hinted at becoming less aggressive in terms of monetary policy, but they should continue to be accommodative nonetheless. Despite its desire to normalize interest rates, the Federal Reserve will also exercise caution with regard to raising rates as the U.S. economy remains fragile. Interest rates are higher than they were just a few months ago, but they are extremely low relative to historical data and are unlikely to spike upward on a prolonged basis.