Despite soft economic data, S&P 500 closes at record high

You ought to be able to explain why you’re taking the job you’re taking, why you’re making the investment you’re making, or whatever it may be. And if it can’t stand applying pencil to paper, you’d better think it through some more. And if you can’t write an intelligent answer to those questions, don’t do it. – Warren Buffett

Despite weaker than expected economic data and disappointing earnings from two major retailers last week, the S&P 500 Index closed at a new record high. Ordinarily, it would take strong economic data, a moderately growing economy and positive earnings surprises to send stocks higher, but this market seems to thrive on the prospect of continued low interest rates. In this case, bad news becomes good news as investors have decided that a June rate hike by the Federal Reserve has been taken off the table and even a September rate hike now seems less certain. A weaker dollar coupled with lower yields and a much calmer bond market all have increased the relative attractiveness of equities and resulted in a market that wants to grind higher. The Federal Reserve has stated time and time again that any increase in the Fed Funds rate will depend solely on the economic data. If last week’s data is a precursor of what lies ahead, investors could be in for a long wait. April retail sales were flat, the producer price index (PPI) and industrial production both fell last month and the consumer sentiment index dropped to a 7-month low. All of this soft economic data serves to keep interest rates low as investors remain hopeful that the economy and corporate earnings will improve enough to justify stock valuations that appear to be full. Two of the country’s top retailers, Macy’s and Kohl’s, also contributed to the malaise last week with disappointing earnings and sales that missed analyst estimates. There doesn’t seem to be a reason for the Fed to tighten, but there also doesn’t seem to be a reason for the stock market to go higher, either, given the recent lackluster economic data.

Last Week

As mentioned above, retail sales last month were disappointing despite cheaper gasoline prices as consumers spent more at restaurants and Internet sites but less for cars, home furnishings, electronics and fuel. Retail sales have turned in the smallest year-over-over gain since October 2009. The core producer price index (PPI), which excludes food and energy, has risen only 0.7% over the past year. Industrial production has now fallen for the fifth straight month.

It was merger mania last week as Verizon Communications agreed to purchase AOL while Danaher announced it would buy Pall Corp. Merger talks are also ongoing between Royal Ahold and Delhaize Group.

For the week, the Dow Jones Industrial Average added 0.5% to close at 18,272 while the S&P 500 Index gained 0.3% to close at 2,122. The Nasdaq Composite Index rose 0.9% to close at 5,048.

This Week

April housing starts are expected to rebound strongly after they plunged in February, continuing the steady but uneven housing recovery. Leading economic indicators for April should be up modestly while the April consumer price index (CPI) is expected to be flat.

Minutes from the Federal Reserve policy committee meeting held in April will be released and investors will be looking for any clues about the timing of a possible interest rate hike based on the Fed’s assessment of the economic data. The Bank of Japan also will make a decision about its monetary policy.

Quarterly corporate earnings reports will be dominated by the retailers this week as Home Depot, Lowe’s, Wal-Mart Stores, Target, Staples, TJX Co., Gap and Best Buy are all scheduled to report. Deere & Co. and Hewlett-Packard are also on tap this week.

Portfolio Strategy

With about 90% of S&P 500 companies having already reported quarterly earnings, the overall results have been generally positive, considering that the expectations had been reduced and were widely known. Year-over-year earnings growth for the first quarter was about 2%, which was better than feared in light of the effects from a strong dollar on multi-national companies and low oil prices on companies in the energy sector. The best performing sectors of the market for the quarter were health care and biotechnology, financials and technology while companies in the industrial sector lagged due to the damaging effects on the bottom line caused by a strong dollar. The most important takeaways from the first quarter were the effects of very weak economic growth on corporate revenue as companies struggled to grow the top line. However, a better economic environment in Europe certainly helped U.S. multi-national companies and European companies that sell their products overseas benefited from a weak euro currency. Finally, corporate profit margins were helped by strict cost controls as well as lower commodity costs and continued low interest rates, which reduces the cost of borrowing. While the second quarter may also be challenging in terms of appreciable economic growth, higher and more stable oil prices should help the energy sector while a slightly weaker dollar should help boost corporate profits. With no immediate threat of higher interest rates and only modest wage growth, earnings growth should increase as the year progresses and provide investors with mid-to-high single digit returns for the year.