The Dow Pulls Back From Record Highs As Geopolitical Tensions Simmer

The Dow Jones Industrial Average, along with the Dow Jones Transportation Average, both attained new all-time highs last week, with the former reaching a best-ever level for the 15th time this year by closing at 17,138 last Wednesday. But from those all-time highs, the market has pulled back somewhat as it had to find a “reason,” so to speak, to cool off a bit and allow for some profit taking.

And it certainly got that excuse to move lower off those highs in spades late last week, with a double-barrel whammy as the result of extreme geopolitical tensions in two parts of the world where troubles had been brewing for months under the surface. These were the four-month-old conflict between the Ukrainian government and pro-Russian separatists in the eastern part of that country and in the long-simmering dispute between Israel and the Palestinians in the Gaza region as well.

Whether the market used the shooting down of the Malaysian passenger jet and the Israeli incursion into Gaza as excuses for some profit taking or stocks would have declined nevertheless, late last week saw two of the most unusual days this year in terms of how equities behaved. For instance, last Thursday the market finally ended its streak of not having moved by more than one percent on a single day for 62 straight sessions as the S&P fell by 1.2 percent as news of those two aforementioned geopolitical items became known during the trading day. Then in an equally astounding session in the completely opposite direction, the market shrugged off Thursday’s downside debacle on Friday by recovering almost all of the losses as the S&P rose by one percent and all the major indexes actually ended the week higher. This was now the seventh straight week where the major averages have closed in the opposite direction from where they had ended the week before.

Before all of the geopolitical fireworks exploded as a background issue, the Federal Reserve once again provided the underlying support that it has been applying to the equities markets for the past five years, as Chairperson Janet Yellen testified to the Senate Banking Committee, followed by her appearance before the House Financial Services Committee as well.

She told lawmakers that the central bank must continue with its record monetary stimulus in order to negate the effects of persistent labor market strains. “There are mixed signals concerning the economy,” she said, “which means that we need to be careful to make sure that the economy is on a solid trajectory before we consider raising interest rates.”

While her “overall view is more positive,” she said that low wages are one sign of “significant slack” in labor markets and this is despite the unemployment rate declining to the lowest level in almost six years. She even showed some empathy toward those without jobs by talking about the “psychological trauma” that the unemployed and their families suffer.

The key words that got the Dow to its best-ever level were her assertion that interest rates are likely to stay low for a “considerable period” after the Fed ends its bond-buying program which could take place after the October F.O.M.C. meeting. “A high degree of monetary policy accommodation remains appropriate” because even though the economy continues to improve, “the recovery is not yet complete,” she added.

She also trod on the slippery slope of a central banker acting like a securities analyst with her pronouncement that “Valuation metrics in some sectors do appear substantially stretched, particularly for smaller firms in the social media and biotechnology industries, despite a notable downturn in equity prices for such firms early in the year.” It would appear that the market itself should determine the prices for individual stocks, rather than a high government official taking on this role for herself. On the other hand, she also mentioned that stock and bond valuations are not out of line with historical norms even as the aforementioned groups seem to be on the high side according to her.

Economic reports issued this past week continue to show a slow, steady recovery with ongoing pockets of weakness as the July New York State Empire Manufacturing Survey rose by more than expected, June retail sales increased as predicted, May business inventories also rose, June industrial production and capacity utilization improved as did the July NAHB Housing Market Index. Weekly jobless claims continued to decline, now down to 302,000, the July Philadelphia Fed Business Outlook improved by more than expected and the June Index of Leading Economic Indicators rose for the fifth straight month. On the other hand, both June housing starts and building permits, a measure of future activity, declined by more than expected with the former at a nine-month low.

Against this backdrop of geopolitical tensions and worries about the sustainability of the economic recovery, the major event facing the market for the next few weeks will be the ongoing second-quarter earnings reporting season. Profits for the first three months of the year rose by 5.5 percent while revenues increased by 3.3 percent. Of the 60 S&P companies to have reported for the second three months of the year so far, the gains are around 6 percent with revenues also ahead by 3.3 percent. What has made the market respond well to these results so far is that 76 percent of the companies that have reported are beating on the earnings side versus the traditional 63 percent that usually surpass here.

Some major companies have provided an upside lift to equities overall with their strong results and the market recovery on Friday was partly attributable to the earnings report from GOOG, which is now the third largest company in the S&P. In addition, good results from the likes of Dow components INTC and UNH, in addition to all-time highs in the shares of HON, have also given support.

This week sees no less than 150 S&P companies reporting, with the largest one of all, AAPL, putting out its results in addition to other high-flying technology firms such as NFLX, FB, AMZN and BIDU, plus Dow components BA, CAT, DD, 3M, T, V and VZ. Hopefully their results will go a long way toward assuaging the market anxieties that these overseas tensions have brought about and will allow the overall uptrend that has been in place this year to continue.

Donald Selkin is the Chief Market Strategist at National Securities in New York, a veteran in the securities industry for 36 years who is widely quoted in the financial media.

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