A string of solid economic reports
Friday’s Labor Department Employment Report came in much stronger than expected with 280,000 people finding new jobs in May. This report capped a string of solid economic reports that point to the US economy rebounding from a weak first quarter.
The stock market doesn’t really know how to view this improvement. On one hand, an improving economy should lead to better corporate profits which should move stocks higher. On the other hand, a strong economy should push the US Federal Reserve to increase short-term interest rates.
It reminds me of the story of a frustrated Harry Truman shouting,
“Give me a one-handed economist!”
The fear that investors have regarding a stronger economy and the possibility of resulting higher rates is not new.
The S&P500 is trading at just over 18 times trailing earnings. That’s not cheap. No one is certain how much of this large multiple is due to short-term rates being zero and whether this premium will deflate if the Fed hikes the Fed Funds rate. It’s the multi-billion dollar question. Mathematically, higher rates reduce asset valuations.
The only offset to this downward force is corporate earnings
The only offset to this downward force is corporate earnings. Many factors came into play in the first quarter that hurt profits.
Winter weather dampened economic activity in the northeast and midwest.
The collapse in oil prices wrecked the energy sector.
A West Coast port strike disrupted supply chains.
The US dollar spiked which reduced profits earned overseas, a big component of S&P500 earnings.
The good news is that all of these issues that crimped profits in the first quarter are either not present or lessened so far in the second quarter. Plus, the European economies have picked up this quarter which should benefit US companies doing business there.
The pieces are in place for corporate profits to show an upside surprise this quarter.
How does the summer play out?
So how does the summer play out? Of course, no one really knows and investors should not focus on the short-run.
Having said that, I don’t think the bull run is over. Aside from the interest rate question, the Greece situation will likely be resolved with some accommodation on both sides and the can will get kicked down the road. This should give a boost to the stock market.
I think earnings will come in better this quarter. The Fed is likely to wait until September to raise rates and the market could be weak come late July and into August.
If the Fed moved in September the initial reaction will be for the market to sell-off. However, I think the sell-off will be short.
One or two rate increases are not enough to significantly reduce the market multiple and stocks should resume their trend higher.
Financial Services stocks look very good in an environment where rates are a bit higher and the economy is performing well.
Bonds may have a rougher time than stocks as rates moving up from very low levels have a meaningful impact on bond values.
— Ian Green, Pendragon Capital Management
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Note: This blog article is intended for general informational purposes only. Nothing in it should be construed as, and may not be used in connection with, an offer to sell, or a solicitation of an offer to buy or hold, an interest in any security or investment product.