By Pete Biebel, Vice President

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The market’s lack of movement persisted through most of last week (see last week’s commentary The Market Needs a Taxative).  Even when a meltdown in China’s Hang Seng Index led to a gap-down opening here on Thursday, most averages were able to crawl back to about even for the day.  Then, that evening, the market got the medicine it wanted: News that the Senate passed a budget resolution. That propelled stocks higher on Friday.  A market that was bound-up waiting for a sign that some action on a tax plan could come soon, bounded up.  Aided by positive earnings surprises from several of its component stocks, the Dow Jones Industrial Average (DJIA) gained 2.0% for the week.  The S&P 500 Index (SPX) gained less than half as much, +0.86%.  The NASDAQ Composite (COMP) could only add 0.35%, less than half as much as SPX.  The Russell 2000 Index of small-cap stocks, which may experience the greatest reaction to good or bad news on tax reform, was in the red for most of the week, but leapt to a 0.44% net gain for the week in Friday’s celebratory session.

Last week’s late week action on the budget, along with its implication of improved odds for a tax package, was just the prescription the market needed to restore the regularity of its progression higher.  The broader measures of the market’s performance were just around breakeven or lower through the first four days of the week.  Fortunately, positive responses to earnings reports in a handful of DJIA stocks early in the week kept the Dow making the evening news with new highs on several of those days.

While the post-resolution gains were significant, the DJIA’s gain last week exaggerates the health of the overall market.  The closing paragraph of last week’s commentary cautioned, “Nine of the DJIA’s thirty component stocks are scheduled to release earnings this week.  Because the Dow is a price-weighted index, as opposed to a capitalization-weighted index, relatively small percentage moves in reaction to earnings news in any of the Dow’s higher priced stocks can create outsized moves in DJIA compared to other averages.”

Clearly that was the case last week.  Five of the DJIA stocks that reported earnings last week accounted for two-thirds of the average’s gain last week.  Another indication of the degree to which the narrow DJIA misrepresented the performance of the overall market is that 90% of DJIA’s components had gains last week.  The ratio of advancing issues to decliners on the NYSE was not quite eight to seven, barely more than 50%.  On the NASDAQ, decliners actually outnumbered advancing issues by a narrow margin.

Again, last week, action in the Utilities sector was unusual.  Recall that in the prior week, potential liability in the California wildfires weighed on the stock prices of some West Coast utilities and erased half of the sector’s gain that Friday.  Last week, the group was the third best of the U.S. equity sectors, gaining 1.31% for the week.  What was unusual, however, was that interest rates moved higher through the week.  The interest rate sensitive Utilities sector tends to weaken as interest rates rise.  Yet last week the group posted a healthy gain even though the yield on 10-Year Treasuries climbed to near its highest level in five months.  The most reasonable explanation for this uncharacteristic behavior is that Thursday’s big gap down, “risk off” opening seems to have fueled some buying in the relative safety of the Utilities sector.  Most stocks in the group had, by far, their best day in weeks on Thursday.

The Financial sector was the big winner last week, up a little more than 2%.  That sector’s path through the week was similar to that of the overall market.  Through the first four days of the week, Financials see-sawed around unchanged.  Even as other sectors, like Basic Materials, Healthcare and Technology, reached marginally higher new highs early in the week, the Financial sector was unable to cash that check.  Then, the budget resolution news caused interest rates to spike higher on Friday, providing a bonus for Financials as the overall market rallied.  Another factor that favored Financials is that, with the improved potential for action on tax reform, any actual package that greatly reduces the tax rate on corporations could be a big benefit for many of the sector’s companies.

Now, adding to concerns about the market’s high valuation, its narrowing breadth and its extremely low volatility, are indications that sentiment, particularly among retail investors, is reaching euphoric extremes.  An article published by Dow Jones MarketWatch claims that retail investors, as a group, believe now is the best time ever to invest in stocks.  The article based its conclusion on a University of Michigan consumer sentiment survey in which 65% of respondents believed that stock prices would be higher over the coming year.  That, according to the article, is the highest percentage in the survey’s history.

While the new highs in the indices, especially the DJIA’s lopsided gains, inspire record optimism among retail investors, the factors listed above suggest that caution may be a more appropriate slant.  I continue to doubt the market’s ability to make significant progress beyond current levels.  The averages are overdue for at least a short-term timeout.  The good news is that now a pullback of even 4% to 5% would not violate any important support levels.

The week ahead brings the largest number of earnings reports yet in the new Earnings Season.  As we saw last week, even a few surprises in just a few stocks can have a big impact on the market.  While the odds of a December rate hike by the Fed ticked even higher last week, Friday’s GDP number could still spark a significant market reaction if the data comes in much lower than expected.

 

Date Report Previous Consensus
Tuesday 10/24/2017 PMI Composite Flash 54.6 54.8
Richmond Fed Manufacturing Index 19  20
Wednesday 10/25/2017 Durable Goods Orders, M/M +1.7%  +1.0%
Durable Goods Orders, ex-Transportation, M/M +0.2%  +0.5%
New Home Sales, SAAR 560K  555K
Thursday 10/26/2017 International Trade in Goods, Trade Deficit $62.9B $64.0B
Jobless Claims 222K 235K
Pending Home Sales Index, M/M -2.6%  +0.5%
Friday 10/27/2017 GDP, Q/Q, SAAR +3.1%  +2.5%
Consumer Sentiment 101.1 101.1