Stocks at all-time highs on Fed comments

A collapse in U.S. stock prices certainly would cause a lot of white knuckles on Wall Street. But what effect would it have on the broader U.S. economy? If Wall Street crashes, does Main Street follow? Not necessarily. – Ben Bernanke

The stock market resumed its record-setting ways last week as both the Dow Jones Industrial Average and the S&P 500 Index closed at new all-time highs on Friday. Increasing sectarian violence in Iraq that caused oil prices to surge took a back seat to the Federal Open Market Committee (FOMC) meeting and Fed Chair Janet Yellen’s reassuring comments about the state of the U.S. economy. In the absence of any market-moving economic data, the FOMC meeting was the main attraction. The Fed announced that its monthly bond-buying program would be reduced by another $10 billion to $35 billion a month and forecast that short-term interest rates would continue to remain low for “a considerable time.” It also acknowledged the fact that economic growth has rebounded strongly in the second quarter after contracting in the first quarter. But it also tempered its outlook for GDP growth to only 2.1% to 2.3% for the year while leaving its inflation outlook unchanged at about 1.5%. While the Fed foresees a faster rate of tightening for interest rates, those increases likely will not occur until mid-2015 at the earliest. Investors chose to react to the positive news from the Fed rather than the negative implications for the market from the crisis in Iraq. With a favorable outcome in Iraq far from certain and the real possibility of a further spike in oil prices, stocks could be vulnerable should the situation there continue to deteriorate.

Last Week

The consumer price index (CPI) rose 0.4% in May, which was higher than expected, and consumer inflation has now risen 2.1% during the past year. The core rate of inflation (excluding food and energy) registered its biggest gain since August 2011. Over the past twelve months, real wages have fallen and, as a result, consumers have had little ability to increase spending and boost economic growth. Housing starts for both single-family homes and multi-family units also fell in May by over 6%.

Jobless claims declined last week as layoffs remain low and more jobs are available. Despite the drop, though, millions of people cannot find work and the number of long-term unemployed remains higher now than before the 2007-2009 recession. The index of leading economic indicators for May rose by 0.5% and was in line with estimates, signaling that prospects for the economy remain bright.

For the week, the Dow Jones Industrial Average gained 1% to close at 16,947 while the S&P 500 Index climbed 1.4% to close at 1,962, both all-time highs. The Nasdaq Composite Index also rose 1.3% to close at 4,368.

This Week

News from the housing sector should be positive this week as both existing home sales and new home sales for May should show improvement over the previous month. Expectations are for both the June consumer confidence index and the Michigan sentiment index to be higher than the prior readings, another positive indicator for the economy. After a strong April, durable goods orders for May could disappoint investors as no increase in orders is expected. Lastly, as far as old news is concerned, the final first quarter GDP number may show that the economy contracted as much as 1.8%.

It will be interesting to see if gold can add to its gains from last week as the precious metal was up over 3%, which was its biggest gain in nine months, as it eclipsed $1,300 an ounce.

Quarterly earnings reports this week are expected from Carnival, Bed Bath & Beyond, Walgreen, General Mills, Monsanto, Accenture and NIKE Inc.

Portfolio Strategy

With the U.S. stock market increasingly appearing fully valued and bonds offering little in terms of attractive yields, one asset class that could be an opportunity for investors is emerging markets. Over the past several years, the performance of developing markets has been disappointing but recent price action of these stocks indicates that this trend may be changing. The MSCI Emerging Market Index is up over 6% this year as economic growth has accelerated in these countries as well as in Europe, where the European Central Bank (ECB) has been very accommodative and recently cut interest rates again. In fact, emerging market countries trade more with Europe that either the U.S. or Japan so this bodes well for future growth. Emerging markets are also trading at lower valuations than the U.S. and other developed countries with a price earnings ratio of about ten times forward earnings estimates. This asset class is not without risk, however, as the pace of China’s growth and political changes can alter the investing landscape in a hurry. But with improving global growth and continued easy monetary policies in the U.S., Europe and Japan, the outlook for emerging markets appears to be more favorable now than it has been in a long time.