Stocks strong on earnings and economic data

Our stay-put behavior reflects our view that the stock market serves as a relocation center at which money is moved from the active to the passive. – Warren Buffett

After a week when the economic data could best be described as lackluster and the statement from the Federal Reserve was more of the same, the stock market continued to defy gravity as both the Dow and the S&P 500 are now perched at record-high levels. While this may sound precarious, it actually is not as the S&P 500 currently trades at a reasonable 15 times estimated earnings for 2014, provided those earnings can be trusted. Though not cheap by historical standards, this level is not considered overvalued, either. As the second quarter earnings season winds down, the news has generally been positive as earnings have beat previously lowered expectations. The news last week on the macro-economic front also was just good enough to appease investors and send stocks higher. Continued improvement in the housing sector in the form of higher prices and sales, better than expected GDP growth in the second quarter, a sizable drop in weekly jobless claims and a small decrease in the unemployment rate all contributed to provide a favorable backdrop for stocks. If you also throw in better than expected manufacturing data from China and continued easy money policies from the Fed, you have a recipe for a strong stock market. Two old investment clichés – don’t fight the Fed and the trend is your friend – are appropriate themes for investors right now. Until something happens to change this view, investors should stay put and enjoy the ride.

Last Week 

The much-anticipated second quarter GDP report came in at 1.7%, compared to estimates of 1%, as consumer spending and business investment were both strong. This report was tempered somewhat by the fact that the 1^st quarter GDP report was revised down to 1.1% from 1.8%. On the same day as this announcement, the Federal Reserve again professed its intention to leave interest rates unchanged and to maintain its bond-buying binge while the economy gradually improves. In fact, the only change the Fed made in its statement was that the economy was expanding at a “modest” pace instead of a “moderate” pace. With the news on Thursday that jobless claims had fallen to 326,000, the lowest level since January 2008, the stock market posted its biggest gain of the week, up more than 1%.

The all-important jobs report on Friday was disappointing but the market seemed to shrug it off. A weaker-than-forecasted 162,000 jobs were created and the numbers for both May and June were revised lower by a total of 26,000. Most of these new jobs were in the retail and restaurant industries and were predominantly part-time. On the bright side, the unemployment rate actually ticked down to 7.4%, a level not seen in 5 years. In corporate earnings news, both Exxon Mobil and Chevron reported weaker than expected earnings for the second quarter while Viacom, LinkedIn, American International Group and Kraft beat earnings estimates.

For the week, the Dow Jones Industrial Average climbed about 100 points to close the week at 15,658, a gain of 0.6%. The S&P 500 rose 18 points to finish at 1,710, up 1%. The Nasdaq turned in the best performance for the week at it closed at 3,690, an increase of 2% or 76 points.

This Week

The week ahead should be quieter as there are only a handful of economic reports scheduled to be released and earnings reports from large cap companies continue to wind down. The ISM (Institute for Supply Management) non-manufacturing index for July should show a slight increase. Other reports of note include the June international trade deficit, expected to show modest improvement, and the June consumer credit report, expected to be somewhat lower than the last period. Economic data from abroad could be more significant as China’s trade balance is announced on the heels of better-than-expected manufacturing data last week. Also, the Bank of Japan will comment on its interest rate policy while Germany will release data on industrial production.

Among companies expected to report earnings next week are Walt Disney, Archer Daniels Midland, Emerson Electric, Time Warner, Duke Energy and Dominion Resources. As you might expect in a strong stock market, there are also a number of IPOs that will be priced on Friday. And not to throw cold water on the stock market rally in July, but data from the last 20 years shows that the Dow has averaged a loss of 0.7% in the month of August, the third-worst monthly performance. Even when on vacation, nervous investors  with smart phones feel a compulsion to stay plugged in to the markets when maybe they should just sit back and relax.

Portfolio Strategy

With the DJIA trading at an all-time high and the S&P 500 hovering above 1,700 for the first time ever, stocks are likely to consolidate their gains over the next few months. Strategists at both JP Morgan and Goldman Sachs have recently raised their year-end target for the S&P 500 to the 1,750-1,760 range, which is less than 3% from where the index closed on Friday. Caution should be the watchword as the August jobs report could be a key determinant as to whether or not the Fed decides to begin tapering at its September meeting. If the central bank does begin to remove the punch bowl, as most market pundits seem to believe, interest rates may continue their upward climb, which could spook the stock market as it did back in May and June. 

For fixed income investors, interest rates have stabilized for now as the 10-year Treasury yields 2.60%, compared to over 2.70% before the lackluster jobs report was released last week. While inflation is benign at the moment, the Fed stated at its meeting that prices are likely to rise in the future. Since most economists expect GDP growth to accelerate for the remainder of this year and into next year, it seems inevitable that interest rates will gradually rise over time, too. In this scenario, investors should limit their interest rate risk by shortening their bond maturities and by focusing on quality. Structuring a ladder of maturities with short-to-intermediate term bonds with investment grade ratings would be one approach. Purchasing bond funds with short average duration inside 5 years would also serve to better protect principal in a rising interest rate environment.