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Yellen soothes markets, stocks at record highs

The four most dangerous words in investing are: ‘this time it’s different.’” – Sir John Templeton

Both the Dow Jones Industrial Average and the S&P 500 Index closed at record high levels last week, marking the sixth consecutive week of gains posted by these two indices. Investors can thank Janet Yellen, the Federal Reserve Vice Chairwoman who has been chosen to replace chairman Ben Bernanke in January, as the person most responsible for the rally in stocks. It was at her nomination hearing on Wednesday that she dispelled any notion that there would be a change in the Fed’s policy of its monthly stimulus program intended to keep interest rates low. The market’s strong performance this year can be partly attributed to the central bank’s easy monetary policies. According to her, any thought of tapering is still on the back burner and would actually do more harm to the economy if it were implemented too soon rather than too late. Investors rejoiced at this dovish tone and proceeded to pile into stocks, sensing that the earliest any reduction in the monthly bond-buying program would happen would be the spring of 2014. In fact, earlier in the week, two Federal Reserve officials had commented that the Fed could possibly taper in December and that quantitative easing could not last forever and would have to end some time. These comments were apparently made in reference to the strong October jobs report and third quarter GDP report released the week before. But it is Janet Yellen as the next Federal Reserve Chairwoman who has the most influence and it was her conciliatory remarks that convinced investors that interest rates will stay low and that the stock market is not overvalued.

Last Week

While economic news last week took a back seat to Janet Yellen’s nomination hearing, some of the data showed an economy that is still sputtering. A New York business conditions index showed that manufacturing contracted in October while prices for U.S. exports also fell last month, a sign of global economic weakness. Industrial production for October declined 1%, which was the first drop since July. To make matters worse, GDP growth in the euro zone slowed to just 0.1% in the third quarter and policy makers there hinted that further action might be needed to spur growth.

Retailers dominated the third quarter earnings reports last week as Macy’s profit handily beat analysts’ estimates while Wal Mart disappointed investors with earnings guidance that fell short of expectations. As we move into the holiday shopping season, many retailers are anxious about slipping consumer confidence and are planning earlier openings on Thanksgiving Day as a way of attracting shoppers into their stores. Same-store sales are only expected to grow a measly 1.6% from a year ago in the fourth quarter.

For the week, the Dow Jones Industrial Average added 1.3% to close at 15,961 while the S&P 500 Index rose 1.6% to 1,798, both record high levels. The Nasdaq Composite Index also participated in the festivities as it climbed 1.7% to close at 3,985.

This Week

Retail sales and the producer and consumer price indices for October will be released and, by all indications, there should be little change in the numbers from the previous month. Inflation continues to remain under control and retail sales should be virtually flat. Minutes from the Fed’s last meeting will also be released and will provide additional information on the Fed’s thinking with regard to its stimulus program.

On the corporate earnings calendar, retailers will again take center stage this week as Best Buy, TJX Co., Home Depot, J.C. Penney, Lowe’s Co., Staples and Target report their quarterly results. Their reports as well as the retail sales number will likely give investors clues about holiday spending.

Portfolio Strategy

Granted, the year is not over yet, but the S&P 500 Index is on track to post its best performance since 2003 as it is up 26% through the close of business on Friday. Small and mid-cap stocks have performed even better as their returns have eclipsed 30% for the year. With such outsized returns, it would be easy to conclude that the stock market is overvalued. To be sure, there are reasons to be cautious about this market: investor complacency, absence of a meaningful market correction, some frothy technology stocks, a booming IPO market and widespread margin debt. But a closer look reveals that the S&P 500 Index is trading at 16 times estimated earnings for 2013 and just 15 times estimated earnings for 2014. Historically speaking, these valuation levels are about in line with the long-term average for the stock market. With the yield on the 10-year Treasury at 2.70% and expected to trade in a fairly narrow range, stocks can afford to trade higher with interest rates at historically low levels.  Compared to the potential returns for bonds, cash and commodities in the short-term, stocks seem to offer the best bang for the buck. That being said, the areas of the stock market that appear to offer the best value include real estate investment trusts (REITs), above-average dividend yielding stocks, certain sectors of the market such as large-cap technology, financial and energy stocks and broad-based international funds with exposure to Europe, Japan and other developed Asian countries. Both Europe and Japan are employing stimulus measures that rival those of the Federal Reserve as they pull out all the stops to reignite their economies.