Dow Jones May Climb on Dovish Fed, Improving Macro Data

DOW JONES INDEX FUNDAMENTAL OUTLOOK:

  • A catch-up play in the cyclical-linked financials, real estate and consumer sectors may lift Dow Jones
  • The Fed has sent a clear dovish message to propel risk assets, sink the US Dollar
  • Better job market sentiment and strong rebound in manufacturing PMI data boosted confidence

Dow Jones Index Outlook:

The Dow Jones Industrial Average stockindex has rebounded 56.4% from its trough observed in March, marking it one of the best-performing stock indices globally after the S&P 500 and Nasdaq index. Last week, Federal chairman Jerome Powell’s speech at the Jackson Holeeconomic policy symposium sent a clear dovish message to stock investors – that the central bank will allow inflation to overshoot for a period of time before stabilizing at a long-term target of 2%.

That meant, the Fed is likely to keep its monetary policy accommodative in the foreseeable future, even if the economy faces overheating and rising inflation during the recovery phase. The message is stock market friendly, and thus may give Dow Jones a strong push to catch up with its Wall Street peers – the S&P 500 and Nasdaq, both of which have already set fresh record highs for a few consecutive sessions.

The fact that the Fed is willing to tolerate higher inflation has pushed the US Treasury yield curve higher, even though the interest rates are kept low. This creates an effective ‘negative interest rate’ environment as inflation may overshoot nominal interests rates. A negative interest rate environment naturally encourages investing and spending, while discouraging savings. Therefore, the Fed’s policy guidance may, in the mid- to long-term, boost cyclical sectors such as consumer discretionary, real estates, and financials.

Besides, the fundamental picture is improving in the United States. A ‘V-shaped’ recovery in global manufacturing PMI readings collected by Markit suggests a solid recovery in demand and supply of goods, showing the resilience of the global manufacturing network in a time of huge uncertainty (chart below). The US job market has shown signs of improving too, as suggested by a fairly smooth decline in weekly jobless claims data (chart below).

Recovery in Markit manufacturing PMI readings globally

Source: Bloomberg, Dailyfx

US weekly jobless claims (in millions)

US Weekly Jobless Claims

Source: Bloomberg, Dailyfx

Doubts remains, however, about the Dow Jones’ rick valuation as the stock benchmark has never been so expensive in the past decade or so. Trading at over 24 times price-to-earnings (P/E), it is at its most expensive level since 2002 – the time of the ‘dot-com’ bubble.

As the Dow moved along its upward trajectory, stocks became more expensive. Rich valuation renders the stock market vulnerable to technical pullbacks should negative catalysts kick in. And the market is never lacking for potential black swan events.

Dow Jones Industrial Average vs. P/E ratio

Dow Jones vs PE Ratio

Source: Bloomberg, DailyFX

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— Written by Margaret Yang, Strategist for DailyFX.com

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