Aug 27, 2013 - Here's what happened in the stock/bond markets last week

Stock Market Analysis

Conclusions: The Dow Jones Industrial Average fell for the third week in a row. The Dow eased 0.47% but broader indices advanced. The S&P 500 rose 0.22% and the small cap Russell 2000 rose 0.61%. This was confirmed as 650 more stocks rose than fell in price. However, the market has been losing momentum and last week we saw almost six times as many stocks hitting new lows as new highs.

Having just returned from a trip to Africa with almost no digital connections, the culture shock is gripping. In Mozambique, a decent job pays $4 a day while most are just $2 a day. Where I was staying about one quarter of the population were orphans, primarily from the AIDS epidemic. In addition, flooding had destroyed tens of thousands of homes, which were only made of reeds to begin with. Still, the human spirit is amazing and the desires of the people are the same as here. They want good things for their children, good health and opportunities to improve their lives. In addition, their spiritual hunger is palpable and I witnessed great joy in spite of destitution that makes our poor seem wealthy beyond imagination.

Returning to our markets, second quarter earnings have been reported and apart from financial firms, the results weren’t stellar. The personal income and spending reports come out this week and it seems many are hoping for good news. The idea seems to be that better jobs numbers will lead to better incomes, which will lead to better spending and then better corporate earnings. That seems to be presuming too many things, any of which may not materialize. That said, the strength in housing this year has translated into higher levels of appliance sales and for other home related items. Fortunately, this was in keeping with our Economic Outlook for 2013.

New home sales slumped in July, most likely because rates have headed higher. One realtor told me one of his contracts fell through because the hike in rates no longer left the client eligible for a loan. The nascent housing recovery is crucial for economic recovery and this scenario will have to be watched carefully. This will mean even closer Fed watching in September.

Historically, August has been a transition month, with little if any gain in the S&P500. That has been true so far this year, as it has fallen 1.12% so far this month. Unfortunately, going back to 1953, September has the worst record of any month. Merrill Lynch points out that September has risen only 44% of the time and had an average drop of 0.62%. It seems investors have started to move to safer ground as over $11 billion was taken out of equity funds last week. This shouldn’t be a surprise given the recent highs and growing uncertainty about Fed actions.

Our indicators still point to elevated risk and our Risk Exposure Ratio estimates a two in three chance of a significant correction. Investors are trying to digest the latest economic reports and guess which way the Fed will go. This is not a market with the fundamentals in its favor, but those who missed the big run up in stocks have grown ever more anxious to get their funds put to work. We might see a near term bounce, but prudent investors will remain cautious and look for better opportunities later this year.

Barry R. James, CFA, CIC

Bond Market Analysis

Conclusions: Bonds had a mixed week. Longer term treasury and corporate bonds advanced in price while Munis and intermediate term treasuries slipped. Year to date, all but High Yield bonds have lost ground. The bond market has been fixated more on the Fed than on the economy or inflation. This is a string that can’t be pulled forever, but it can certainly jerk the market around for a while.

Last week the Fed minutes came out and it seemed to indicate the FOMC was ready to support Chairman Bernanke if we wanted to start tapering the bond purchases the Fed had been making. A recent survey by Bloomberg shows about 65% of economists expect this tapering to start in September.

All of this will be dictated by economic progress. It is hard to imagine the economy will take off in the next few weeks. However, jobless claims (over the last month) hit a 5 year low. The Leading Economic Indicators advanced and Home Depot is reporting strong sales of appliances. Inflation remains a distant worry and gasoline prices have fallen 20 cents from a year ago. In addition, as I saw in Africa, the dollar remains strong against most currencies. All of these would allow the Fed to begin the tapering program.

As we’ve stated many times, rates actually have tended to rise during Quantitative Easing and have fallen after it has ended. Removing the Fed buying program will likely return the market to focusing on fundamentals which don’t suggest any need for significantly higher rates. However, in the near term, investors are convinced bonds are like Kryptonite to Superman and want little to do with them.

Our risk indicators are neutral and do not suggest taking an aggressive stance toward longer term bonds. We have researched bond returns over many years, including the dreaded 1970’s, when we were just starting. We have found that intermediate term bonds are very helpful in controlling risk, lowering volatility and only rarely have down years. Our indicators suggest taking a neutral approach to bonds and focusing on intermediate term maturities. We have been moving in that direction since June and it would be wise to continue to do so.

Barry R. James, CFA, CIC