Jul 29, 2014 - Here's what happened in the stock/bond markets last week

Stock Market Analysis

Conclusions: Stocks lost ground with the Dow losing 0.8% for the week while the S&P 500 held even. Unfortunately, the same cannot be said of small cap stocks – the Russell 2000 fell 0.6%. A few more stocks fell than rose but we still saw about 4 times as many stocks hit new highs as new lows. Two thirds of the sectors fell on the week with Energy and Technology holding up the best while Utilities took it on the chin.

One way of considering the market is by looking at the number of stocks locked into a bear market. That is, how many of the stocks have fallen 20% or more from their 52-week highs. Our research suggests a significant difference between large cap and small cap stocks. Recently, we found about two out of every three small stocks were in a bear market. However, when looking at the large cap S&P 500, only 4.5 in 10 were in a bear market. We have been saying for months that we were favoring larger cap stocks and this trend has held up very well. This is not to say large cap stocks will not follow their smaller brethren, but as expected, they tend to hold up better.

Our leading intermediate term indicators have been trending negative and a correction of over 10% is long overdue. We have now gone almost 800 days with no such correction. Looking historically, the longest such non-recessionary period was nearly 3000 days but it only happened once. In reviewing the data, we notice the longer the period between corrections, the greater the correction seems to be.

We have started earnings season and the early results are encouraging, giving hope to stock investors. We have seen reasonable increases in revenues and solid improvements in income. We also continue to see a steady pace of takeovers, but with an interesting twist. Many of the takeovers are designed to take advantage of tax benefits from overseas operations. Since the U.S. has the highest corporate tax rate in the industrialized world, this should not be a surprise. After all, if you build the loophole, they will come. Nevertheless, the takeover push has been especially good for mid cap stocks.

As we look over the market, we find excess bullish sentiment. A number of pundits claim stocks still have a double digit rise left in them this year. As we look at sentiment surveys and other measures of sentiment, we still find too much bullishness. Fortunately, investors still remain skeptical after 2008, and caution hasn’t been dismissed.

We would like to see our indicators improve as the market cools down, but we have not seen that yet. Given their negative array, we would continue to sell stocks in overinvested accounts and maintain more defensive positions as appropriate. We will likely have excellent buying opportunities later in the year and believe it is best to only hold modest equity levels at this time.

Barry R. James, CFA, CIC

Bond Market Analysis

Conclusions: Most of investors’ attention was focused overseas, which seemed to help bonds rally once again. Long term Treasuries did the best, with returns over three quarters of a percent. Corporate and muni bonds did well and even Treasury Inflation Protected bonds returned more than 0.33%. Intermediate term Treasuries did nothing while GNMA bonds actually fell a little. Bonds were also helped by the fact that stocks languished during the week.

The Chicago Fed National Activity report came out and showed little activity, although it was not negative. It did slow some in June from the previous month and the slowing was focused in production housing and consumption. Employment actually picked up a little. The other two Fed reports, Richmond and Kansas City showed steady improvement in their regions. Durable goods numbers on Friday also left mixed feelings. The base number was positive and nondefense capital goods orders picked up but shipments fell. This again leaves no clear conclusions about the economy. When in doubt, it seems investors will get cautious and buy bonds.

On the international front, planes continue to crash, problems in the Middle East are at the boiling point and Russia continues to flaunt its status. Throw in immigration and legal woes for the Affordable Health Care Act, and it is no surprise the investors are growing more cautious.

Inflation has been a major concern for bond holders and those of us buying groceries and gas have seen it rise in those two areas. The Consumer Price Report showed modest gains in inflation, running at a 2.1% pace over the last year. This is not enough to reverse the Fed’s course of action, which appears to be: ending Quantitative Easing; looking for a time to liquidate holdings and trying to define circumstances that would necessitate raising rates. For now, option one seems the only path they are willing to take.

Our bond indicators have been positive for some time and they remain so today. Recent volatility has given opportunities to purchase bonds at reasonable prices. We might see a pause in the bond rally, but it has some depth to it, and could pick up more steam if stocks wallow. We would stay with high quality bonds and moderate durations.

Barry R. James, CFA, CIC