Stock Market Analysis
Some stock indices hit record levels this past week. The Dow rose 3.5% while the small cap Russell 2000 rose 4.9%. The advance was deep and wide. Three times as many stocks advanced as declined and the same was true of the number setting new highs versus new lows. Like the early snowstorms this weekend, it was a surprise to see new highs so soon after prices had slumped. However, over the last 3 years investors have been trained that any dip in prices is a buying opportunity.
With the end of Quantitative Easing, the market will have to stand on its own two feet rather than relying on the Fed to bribe investors into buying stocks. The last two times QE ended, stocks slumped, and the economy wasn’t that much better than before QE. The market is trying to determine if that will be the case this time or not. If the economy and profits continue to rise, then stocks would remain a viable asset class. Profits have been steady and even revenues have been rising. However, all of this is threatened by weakness overseas and a rising dollar.
Following the twists and turns in the market has been hard this year. Early on, Utility stocks lagged, but lately they have been the best performers. Energy stocks, supposedly the beneficiaries of increased U.S. production, have lagged dramatically and have barely advanced this year. In addition, we had seen a major bear market in smaller stocks that appears to be reversing. At the end of September, more than 6 out of 10 small stocks (less than $1 billion) were down 20% or more from their recent highs.
Now, we are seeing small stocks outperforming. This isn’t too much of a surprise since we have entered the best part of the election year cycle for small stocks. The current 4 quarters has historically been the best for small cap stocks. In addition, after falling in the first 3 quarters of the year, small cap stocks became less expensive and actually are cheaper than large caps. Lastly, if world economies continue to weaken, companies with greater domestic exposure should do relatively well, certainly a positive for smaller stocks.
Our indicators remain in neutral territory, but actually improved a little last week. Congress is out of session and there may be renewed hope that change will finally come to Washington. It may be false hope that will fade after the election, but for now it seems to be propelling the market. Little else has really changed so we would maintain a modest exposure to stocks until we get further confirmation from our risk indicators.
Barry R. James, CFA, CIC
Bond Market Analysis
Bonds sold off last week as stocks once again rallied. All major bond indices, except high yield, were flat or fell. We actually saw 2 and 5 year treasury bonds see more of a move than longer treasury bonds. In fact, the 30 year treasury yield actually fell. Much of this may be due to the fact that the Fed decided to terminate Quantitative Easing and bond investors are starting to hedge their shorter positions against an eventual Fed hike in short term rates.
Of course, the Fed posture was reaffirmed by solid 3rd quarter growth in GDP. The results, 3.5% annualized growth, was above expectations. GDP growth was perversely helped by a slowdown in imports. However, government spending at all levels, perhaps in anticipation of elections this coming week, were a solid boost to growth. In good news, final sales, personal consumption and nonresidential investment all rose. These have been keys we have been looking for to confirm the economic recovery is starting to gain wider traction.
Bonds should have been reassured as the broadest measure of inflation, the Personal Consumption Expenditure Index, decelerated to an annual rate of only 1.3%. It is interesting to note that lower inflation gives the real GDP figures a boost. However, the Fed is unhappy with inflation below 2% and actually would be happier with 2.5% inflation. They have indicated they will continue to keep their $4.5 trillion in bonds and will keep interest rates low for an extended period of time.
All along, we have said the recovery won’t really have taken hold until home prices and sales picked up. This had been the case until a few months ago. According to the Case – Schiller index, home prices saw another downturn, the fourth in a row. Still, they are up nationwide about 5.6% over the last year but even this is down from double digit gains earlier in the year. Even though mortgage rates are low, incomes haven’t improved and job creation has been focused on lower income and part time work.
Our bond risk indicators had moved from bullish to neutral a few weeks back and we are glad we made the shift from longer bonds to intermediate term bonds. While it doesn’t appear rates are likely to rise rapidly, it is wise to keep some powder dry if longer bonds present another opportunity.
Barry R. James, CFA, CIC
