S&P 500 at all-time high on ECB rate cut

Money is better than poverty, if only for financial reasons. – Woody Allen

The major stock averages closed modestly higher last week on news that the European Central Bank (ECB) decided to cut its key interest rates from an already low 0.15% to .05% in an attempt to stimulate weakening economies in the euro zone. The S&P 500 Index managed to close at yet another record high in the holiday-shortened week. In addition to lowering interest rates, the ECB also announced plans to buy bonds such as asset-backed securities and residential mortgage securities just as the Federal Reserve is within one month of ending its bond-buying program. Desperate times call for desperate measures and Mario Draghi, the president of the European Central Bank, has proclaimed before that he will do “whatever it takes” to save the euro and preserve the euro zone. European economies only grew by 0.2% in the second quarter and a weaker euro currency could have the effect of making European exports more competitive in overseas markets and spurring an economic recovery. Time will tell if the plan is working but since the euro zone accounts for about one fifth of the world’s gross domestic product, it’s important that Europe reverses its slowdown and begins a path toward sustained economic growth. Certainly prolonged weakness in the euro zone has the potential to negatively impact growth in the U.S. and represents a risk to the earnings of multinational corporations that do business in these countries. The U.S. can ill afford to have a slowdown in Europe adversely affect its economy just as economic fundamentals here are improving and growth in GDP is accelerating.

Last Week

There were several economic reports released last week that put the manufacturing sector in a favorable light. The ISM manufacturing index for August reached its highest level since early 2011 and new orders posted their best reading in ten years. July construction spending also was better than expected and factory orders were strong due to a surge in orders for commercial aircraft. U.S. automobile sales in August easily beat estimates and were at their highest level in nine years. The Federal Reserve released its Beige Book, a monthly report on the economy in each of the districts, and concluded that the economy is expanding at a moderate pace.

The employment report for August showed that the U.S. economy created only 142,000 new jobs, far less than the 225,000 that were expected. This was the smallest gain since December and ended a streak of six straight months of 200,000 or more jobs. Most economists dismissed the report as an aberration as the August report is historically known for sharp revisions. The unemployment rate fell from 6.2% to 6.1% as more people dropped out of the workforce.

For the week, the Dow Jones Industrial Average edged up 0.2% to close at 17,137 while the S&P 500 Index also rose 0.2% to close at 2,007, another record high. The Nasdaq Composite Index inched up 0.1% to close at 4,582.

This Week

The calendar this week is light in terms of economic data with the most important release being August retail sales, which are expected to increase 0.5% on strong automobile sales. Overseas, China is expected to report declines in both its consumer price inflation (CPI) and its producer price inflation (PPI).

At a company event, Apple Computer is expected to unveil upgrades to its iPhones, two new smartphones and a wearable device for your wrist called the iWatch.

The earnings calendar this week is also light as notable companies due to report include Campbell Soup, Barnes & Noble, Kroger, Darden Restaurants and Pep Boys.

Portfolio Strategy

With the S&P 500 Index perched at an all-time high above the 2000 level, it would be safe to assume that the stock market is overvalued, especially after surging over 30% in 2013 and gaining another 10% this year with dividends included. But a closer look reveals that despite this strong performance, the market trades at only about 16 times estimated earnings for the next twelve months, just slightly above the long-term average price earnings ratio of 15 based on forward earnings. Until now, strong earnings have driven equity performance and profit growth is forecast to accelerate even faster next year. While equities are certainly not undervalued compared to their levels a year ago, they do seem relatively inexpensive compared to U.S. Treasury bonds, which have risen in price and now offer very low yields.  As the stock market enters the historically weak months of September and October, a pullback or correction is definitely a possibility. The end of the Fed’s bond-buying program next month or the onset of a recession in Europe could trigger investor anxiety, not to mention escalation of political tensions around the globe. But the stock market has been remarkably resilient over the past two years as investors have continually come in and bought stocks on any weakness. With economic fundamentals improving, growth in GDP accelerating and corporate earnings rising, a strong case could be made that stocks offer value at current levels and could have some additional upside.