Stocks Near Record Highs on Job Gains

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U.S. equities surged higher on Friday in response to a surprise June jobs report that blew every Wall Street estimate out of the water and represented the largest positive surprise to expectations since December 2009.

While this ostensibly increases the risk of Federal Reserve interest rate hikes this year — something the futures market isn’t pricing in until the end of 2017 or the beginning of 2018 — investors were content to focus on the positive to the economy from the hiring blitz.

Payrolls jumped 287,000 versus the 180,000 expected and the downwardly revised 11,000 gain in May (which was the weakest in almost six years). Average hourly earnings posted a 2.6% year-over-year jump, the best wage gain since July 2009.

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In the end, the Dow Jones Industrial Average gained 1.4%, the S&P 500 gained 1.5% to close just shy of a record, the Nasdaq Composite gained 1.6% and the Russell 2000 gained 2.4%. Treasury bonds were oddly stronger (as the deflation/fear trade continues), the dollar was mixed, gold lost 0.3% after recovering from deeper morning losses, and oil was largely unchanged near $45 a barrel.

Material stocks led the way higher, rising 2.5% followed by industrials, up 1.9%. Defensive telecom, utility, and staples stocks were the laggards.

Gap Inc (NYSE:GPS) gained 4.9% on a 2% rise in June comp-store sales vs. the 3.1% drop expected. Old Navy was a standout, with comps up 5%. Juno Therapeutics Inc (NYSE:JUNO) dropped 31.9% after the FDA placed its phase-2 study of JCAR015 on hold for certain leukemias following three patient deaths.

Large-cap stocks are now within a hair of their record highs and could be on the verge of breaking out of a three-year-long sideways crawl.

But there is a catch: The ongoing strength in the labor market, and the relatively muted market and economic impact of the Brexit vote, puts pressure on the Federal Reserve to stick to its guns and raise interest rates this year. For a financial market still very dependent on the Fed’s monetary morphine, this will be a problem.

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As a reminder, there remains a wide expectations gap. Fed policymakers, as revealed in their June update of their Summary of Economic Projections, continue to forecast two quarter-point interest rate hikes this year. The futures market, on the other hand, doesn’t expect the Fed to move on rates until the end of 2017 or the beginning of 2018.

While the Fed assures us every policy meeting is “live” for a rate hike, the upcoming July meeting seems too soon to take action. Watch for a possible move at the September meeting followed by another possible move in December.

For now, investors continue to completely dismiss the possibility of higher interest rates anytime soon. A “buy no matter what” dynamic has set in. If job growth slows, the Fed will surely stay on hold, so buy. If job growth accelerates, that’s good for the economy, and the Fed is still likely to stay on hold so buy.

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Yet this ignores a long list of other headwinds: Uneven economic data, an ongoing corporate earnings recession, unknown Brexit fallout, seasonal headwinds (Sell in May?), panic bids in government bonds and precious metals, narrow market breadth with less than 60% of stocks in uptrends, and trying price-to-earnings valuations.

That just demonstrates how focused this bull market is on Fed policymaking. It’s no coincidence that the large moves in the stock market have been mirroring the Fed’s balance sheet. When the QE3 bond buying program stopped in 2014, the upward march of stock prices stalled as well. Since then, the Dow Jones Industrial Average has struggled to stay near the 18,000 level.

What could change all of this? Undeniable evidence of wage inflation, a powerful precursor of overall inflation and a sign that the economy has hit full employment. Capital Economics notes that average hourly earnings rose at a 2.6% annual rate in June, the highest reading so far this year, as a variety of survey indicators keep suggesting an acceleration to 3% is likely over the coming months.

We will know more on the Fed’s thinking when it releases its next policy statement on July 27.

Corporate fundamentals are about to make a return as well: The second quarter earnings reporting season starts on Monday when Alcoa Inc (NYSE:AA) reports, followed by big bank earnings from JPMorgan Chase & Co. (NYSE:JPM) on Thursday and Wells Fargo & Co (NYSE:WFC) and Citigroup Inc (NYSE:C) on Friday.

As things stand, bad news is coming: According to FactSet data, analysts expect S&P 500 earnings to decline 5.6% from last year, which would mark the fifth consecutive quarter of falling profitability. Moreover, evidence suggests the earnings recession is set to continue through the end of the year.

Expectations have been on the slide as headwinds including strength in the U.S. dollar, energy prices that remain well off of their 2014 highs, and falling labor productivity and higher unit labor costs.

The combination of stock prices within inches of record highs and the ongoing slide in earnings continues to put upward pressure on market valuations. The S&P 500’s 12-month forward price-to-earnings ratio is 16.6, above the five-year average of 14.6 and the 10-year average of 14.3. By this measure, stocks are downright expensive given faltering profitability.

Over the horizon, hope springs eternal as both earnings and revenue growth is expected to return in the second half of the year.

Yet analysts tend to be an optimistic bunch that, on average, overestimate actual earnings growth in the second half of the year by nearly 5%. If this is applied to the 4.2% growth expected for the second half, earnings are likely to drop 0.5%.

In other words, as things stand now the earnings drag is set to continue. And that’s why I continue to focus on defensive areas such as precious metals as stocks look increasingly vulnerable to a return to reality. The July $17 iShares Silver Trust (ETF) (NYSEARCA:SLV) calls are up more than 420% for Edge Pro subscribers since recommended on June 24.

Anthony Mirhaydari is founder of the Edge and Edge Pro investment advisory newsletters. A two-week and four-week free trial offer has been extended to InvestorPlace readers.

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Article printed from InvestorPlace Media, https://investorplace.com/2016/07/stocks-near-record-highs-on-job-gains/.

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