Equity Overview

Building on the new highs reached in January, the major indices continued still higher in February.  Most notably, the Dow Jones Industrial Average hit 21,000, less than a month after reaching 20,000.   And the market capitalization of the S&P 500 reached $20 trillion for the first time, a dramatic increase over the past few months.

Large and mid-cap indexes continued to outperform small caps.  As in the prior month, investors favored growth over value stocks.  Stocks in companies with positive earnings surprises did particularly well.  Bank stocks rose with the expectation that Dodd-Frank regulations will be loosened and that the Fed will raise interest rates fairly soon.  Banks tend to perform better with less regulation and a higher interest rate environment.

Earnings season wrapped up with signs of positive momentum.  With 98% of  S&P 500 companies reporting, the average earnings beat rose to 2.8% above expectations (up from 2.5% in January).  And the blended earnings growth rate rose to 4.9% (higher than the 3.1% projected in December and the 4.6% recorded in January).

Macro Overview

Economic news during the month was encouraging, with manufacturing, services, retail sales and consumer sentiment all positive.  Significantly, employment ended a 3-month soft patch with the Department of Labor reporting a gain of 227,000 jobs.

Consumer prices reported in February jumped 0.6%, the largest increase in almost four years.  Core inflation, which excludes food and energy prices, rose 0.3%.  Inflation can impact the stock market negatively when the economy is overheated.  But in the current environment, with somewhat sluggish growth, inflation can be viewed positively because it suggests that the economy is growing.  Thus, the rise in consumer prices was generally viewed as benign, if not positive.  Even the prospect of the Fed raising interest rates has not fazed the markets.  Analysts have suggested that a normalization of interest rates from their artificially low levels in recent years could reduce excessive risk-taking and correct other market distortions.

Executives from 16 major U.S. companies urged Congress to pass a comprehensive rewrite to the U.S. tax code, including implementing a controversial border tax.  As we pointed out last month, a border tax would make U.S exports more competitive in the international markets but would pressure margins for companies that rely on imports such as retailers and auto manufacturers.  The president has not yet endorsed such a tax and its future is uncertain.  In any case, the Tax Policy Center, a nonpartisan independent entity in Washington, believes that any new tax proposals may not gain congressional approval until 2018 at the earliest.

While retail sales were generally positive, the results were not uniform.  Many U.S. retail stores are struggling due to e-commerce competition and slowing mall traffic. According to Moody’s Credit Rating agency, this has led to the highest level of credit distress in the sector since the recession of 2008-2009.