Even if you identify the managers who have good past performance, there’s no guarantee that they’ll have good future performance. – George Sauter, Vanguard Group
Stocks continued their winning ways last week as both the Dow Jones Industrial Average and the S&P 500 Index posted modest gains. Although there was a full plate of economic news for investors to digest, much of the data was mixed and inconclusive with regard to providing clues about the strength and direction of the economy. On the other hand, corporate earnings reports left no doubt about the health of the economy as almost 70% of companies that have reported so far have beaten analysts’ estimates. During the month of October, the S&P 500 posted a total return of 4.6%, thanks to these better than expected earnings as well as continued easy monetary policy, compliments of the Federal Reserve. Maybe it’s this latter reason that accounts for the fact that so many investors hate this market or do not think the rise in stock prices is justified by fundamentals. No one seems to trust this rally or believe in its staying power since to many it is artificially induced by the Fed’s massive stimulus program that seems destined to last as long as the Energizer bunny. To be sure, the consensus for any Fed tapering has been postponed to the spring of 2014 or possibly later, whereas just recently everyone was convinced it would happen in September. It’s this complacency and lack of any macro-economic news on the calendar that could lead to expanding price earnings multiples and still higher stock prices. With earnings season drawing to a close, caution should be exercised as a mild correction of a few percentage points would not be a surprise.
While the Federal Reserve left monetary policy unchanged last week, which was widely expected, economic data that had been delayed due to the government shutdown left investors with few clues on the overall health of the economy. Negative indicators included pending home sales, which fell to a nine month low in September as higher mortgage rates and higher home prices discouraged prospective buyers. Consumer confidence also plunged in October as consumers became less optimistic about the future. This downbeat outlook affected retail sales as they fell slightly in September due to a decline in automobile sales. Finally, Automatic Data Processing (ADP) reported that only 130,000 private sector jobs were created in October, the fewest number of jobs in six months.
On the bright side, industrial production registered its biggest gain in seven months while the ISM Index, a measure of manufacturing activity, had its best showing since April 2011. Both pieces of data confirm a manufacturing sector that continues to expand at an accelerating pace. Jobless claims also fell for the third week in a row, indicating an improving labor market. Both the producer price index and the consumer price index showed that inflation is still under control and is increasing at a rate that is below the Fed target of 2%.
For the week, the Dow Jones Industrial Average rose 0.3%, the S&P 500 Index inched up 0.1% while the Nasdaq Composite Index bucked the trend and fell 0.5%.
The highlight on the economic calendar this week is the third quarter GDP report, which is expected to show tepid growth of 2.0% or even less. Such weak economic growth coupled with an annualized core inflation rate of only 1.2% provide all of the rationale the Fed needs to continue its monthly bond purchases to keep interest rates low. Also on the calendar is the employment data for the month of October, which will provide additional ammunition for the doves as the number of new jobs created is only expected to be about 122,000 and the unemployment rate is expected to tick up to 7.3%.
The European Central Bank meets on Thursday and while it’s likely that interest rates won’t be cut, the tone of the news conference should be very accommodating. On the earnings front, several of the more prominent companies scheduled to report include Kellogg and Sysco in the consumer non-durables sector, Walt Disney and Time Warner in the consumer cyclical sector, Devon Energy and Anadarko Petroleum in the energy sector and Qualcomm in the technology sector.
While the stock market appears somewhat extended right now and due for a breather, municipal bonds are cheap and offer compelling value for tax-sensitive investors. When the 10-year Treasury yield rose to 3% in September on fears of possible Federal Reserve tapering, taxable as well as tax-exempt bond prices declined in value. Municipal bonds have also been affected by the fallout from the Detroit bankruptcy filing and the possible implications it may have for other municipalities. Continued modest economic growth, benign inflation data and persistent high unemployment favors bonds as interest-rate risk should be reduced, offering bondholders stability, value and peace of mind. The 10-year Treasury yield has declined to about 2.60% and will probably trade in a fairly narrow range for the foreseeable future in this type of economic environment. In addition, the Fed is unlikely to reduce its monthly bond purchases designed to keep interest rates low until the first quarter of 2014, at the earliest. While municipal bonds typically trade at yields that are less that those of comparable taxable fixed income investments because of their tax-favored treatment, just recently 10-year, AAA-rated municipal bonds traded at over 100% of the yield of a 10-year Treasury note. With yields on intermediate-term municipal bonds so attractive relative to their taxable counterparts, it makes sense for tax-sensitive investors to consider them for the fixed income portion of their portfolios.