Stock Market Analysis
The Dow and the S&P 500 hit new record highs this last week. The Dow rose 1.06% while the small cap Russell 2000 fell 0.1%. Advancing stocks outpaced fallings stocks by a 19 to 12 margin while new highs swamped new lows.
The real question we all focus on is where is the market going from here? No one really knows, and we would not be honest if we said we do. However, when it comes to investing, having a disciplined approach that is repeatable over time tends to put the odds in one’s favor. We have been doing this for 42 years, and while the markets keep us humble, we have learned to trust our approach. The key longer term elements we have learned to trust are primarily economic, valuation and sentiment indicators. Every two years we reevaluate every indicator to be sure it is still providing useful guidance. Conditions and markets change and we have to continually refine our analysis of risk.
On the economic front, we find it strongly favorable for stocks. In this area we have 18 positive and only 4 negative readings. This is usually a very good condition for stocks over the next 12 months. We took a look at economic growth and stock returns going back to 1930 and found interesting results. During years when the economy was very weak, stocks declined an average of 6%. When economic growth was extremely strong, results improved, but to a paltry 2.7% return. However, during normal periods for the economy, stocks averaged 10.5% a year. We do not see either of the extreme conditions on the horizon, and while no guarantee of strong markets, this is a favorable sign for 2015.
We are not so sanguine when we look at valuation levels. Valuation levels give almost no guidance on timing the market, but they should color how investors think of risk. Low valuations tell us risks are low and we can take a more aggressive approach to investing over a long period. Above normal valuations alert us to the fact the markets could show weakness if bombarded with negative catalysts. The good news, we have one major valuation indicator, Earnings Yield, which shows the market is undervalued. On the other hand, we have many that show the market is not cheap. For instance, the median price to sales level for the S&P 500 is twice its average and running at record levels. In addition, Q Factor (measuring the value of companies versus their replacement cost) shows levels last seen in 1999. Fortunately, most other valuation measures are not at such extremes but they are at elevated levels. This tells us the market could be susceptible if perfect economic conditions fade.
Lastly, sentiment is very telling. Sentiment indicators are probably most useful in the intermediate term rather than projecting for an entire year. We are sorry to say that many of these readings are pointing to excessive optimism. For instance, margin debt levels (borrowing money to buy stocks) were recently at record levels and have moved a bit lower. This happened in 1999 and 2007 and it was a good sign of trouble ahead. We are also disturbed by very bullish sentiment readings and heavy issuance of Initial Public Offerings (IPO). IPO issuance is on pace to exceed 1999. We have also noted a major trend the public is taking toward buying passive rather than actively managed investments. ETF purchases are running at almost 3 times the pace of actively managed mutual funds. While this creates a virtuous cycle for a time, when conditions reverse, it exacerbates the decline. We are not directly comparing the coming year to 1987, but this type of investing did help create the Crash of ’87.
Our interpretation of all this research is that stocks may be in a sweet spot for a while longer, but they are susceptible to shocks and we could see more violent moves than we have in the last few years. That being said, our intermediate term indicators are neutral to slightly favorable. We would take a neutral approach to stocks at this juncture, buying equities for underinvested accounts, but not being shy to lower equity levels if we see a shift in risk levels.
Barry R. James, CFA, CIC
Bond Market Analysis
The U.S. Bond market, represented by the Barclays Aggregate Bond Index, ended the week about where it started. However, some individual sectors of the bond market did well. U.S. Treasury bond prices across all maturities rallied. The best performing were Long Term Treasuries, rising about 0.5% on a total-return basis. Mortgage bonds and Corporate bonds also rose in price, however Municipal bonds fell last week.
The U.S. Dollar rose about 1% last week bringing its year to date performance to +9% against other major trading partners. Commodity prices are down about 7% in 2014 although they also rallied about 1% last week. Gold and silver rallied on the week, but mining shares showed the most luster, up about 5% on the week.
Industrial production data in the U.S. was released on Monday and it was a disappointing report. All three sub-indices were less than expected although manufacturing remains in a moderate uptrend according to the report.
Inflation data at the Producer and Consumer levels (PPI and CPI, respectively) rose about 1.7% over the past 12 months. Our research indicates this should be good for stocks as companies are able to pass on their cost increases to consumers. Price declines in energy, used cars and apparel were offset by increases in just about everything else at the consumer level. Amazingly, we note that even after this report, 5 year and 10 year inflation assumptions continue to decline, a good thing for bond investors.
Housing data released last week included Housing Starts and Existing Home Sales. Housing starts were less than expected but still exceeded 1 million units. The disappointment last month can be traced to a decline in the construction of multifamily units which have provided much of the recovery in the housing market. Also confirming the housing recovery, framing lumber prices dropped to $323 dollars per 1,000 board feet last week. While not back to the high of $455 reached in May 2004 prices are more than double the low of $138 reached in January of 2009.
The Federal Reserve Open Market Committee (FOMC) released the minutes of their recent meeting Wednesday. The minutes showed that the FOMC sees the risks to the economy as “balanced” and that they believe inflation will likely remain low in the near term, but increase to their target over the long term. They are also predicting that the Federal Funds rate will rise to 1.5% by the end of 2015.
We think that the 1.5% Federal Funds rate is less likely to be reached by the end of the year. The FOMC may start the process of raising rates but we think they will be very slow and deliberate in doing so. While increases in short term interest rates would help savers, the FOMC does not wish to derail the recovery and upset the bond market.
Our bond risk indicators continue to be neutral in the intermediate term. This is in contrast to a very bullish posture earlier in the year. While we are not as positive on bonds as we have been in the past, we are not negative. Bonds represent an excellent defense against stock market volatility. We recently took profits, lowered durations and became more defensive after the strong returns long term U.S. Treasury bonds have enjoyed earlier in 2014.
Matt Watson, Portfolio Manager
