Aug 5, 2014 - Recent Market Commentary by James Investment Research

Stock Market Analysis

Conclusions: It was a wild week on Wall Street. The large stocks of the S&P 500 and the smaller issues of the Russell 2000 both fell about 2.6% on the week. As one can imagine declining stocks vastly outpaced advancers with two stocks down for every one stock that was up. The Energy and Industrial sectors took the biggest hits as both lost over 3.5%. Indeed the decline pushed the Dow Jones Industrial Average back into negative territory for the calendar year.

Why the sell-off? It seems the stock market now believes good economic news is bad stock market news. The theory is a good economy will not only cut off the Quantitative Easing (QE) spigot from the Federal Reserve, but it will accelerate the timing of Fed Fund rate hikes as well.

Certainly the second quarter GDP number was an eye opener. Growth of 4% in a quarter has been a somewhat rare event as of late. Starting in 2000 it has only occurred in seven previous quarters (compared to nine quarters of contraction). However, much of this may have been a rebound effect from such a poor economic first quarter.

Perhaps reviewing longer terms may make a clearer picture. On a year-over-year basis GDP has grown 2.4%. By no means is this a bad number but it certainly is not phenomenal. What is worse is the composition of the growth. ZeroHedge noted this week that over half of the growth over the last year came from inventory buildup. As many might recognize growth in inventories is not necessarily the same thing as improving sales.

Looking at the earnings’ picture seems to confirm these concerns. So far approximately 76% of companies have made their quarterly report. Earnings’ growth for these reporting companies has been excellent and has come in just a shade under 10%. But what of the sales? Here the data is more disquieting. Only the Health Care sector has enjoyed double-digit sales growth. Without Health Care the market’s sales growth is only a paltry 3.3%. Higher inventory and struggling sales may not be a good long-term mix.

The employment situation is an improving one. For the sixth consecutive month employment gains topped the 200,000 mark. While job gains are always a welcome sign there is the small matter of the quality of the jobs. Before the Great Recession full-time jobs topped 122 million. Today, five years beyond the recessions end, and our full-time jobs stand at 118 million.

Previously our leading indicators had suggested selling for accounts overinvested in equities. With the recent sell-off one would hope to see improvement in the indicator array and indeed there has been improvement. Unfortunately we are not seeing levels that suggest the market is in an “all-clear” situation. While a short-term bounce is certainly possible the prudent course for now remains to have a conservative approach with only moderate exposure to equities.

David W. James, CFA

Correction: In last week’s commentary we stated “...only 4.5 in 10 [S&P 500 stocks] were in a bear market.” This was a typo. The correct data should have read “...approximately 4.5 in every 100 S&P 500 stocks were in a bear market.”

Bond Market Analysis

Conclusions: This was a week of big moves as the Dow lost 2 ¾%, more than 400 points and, surprisingly, yields on the 30 year Treasury bond rose 5 basis points. Shorter bonds were better behaved; the 2 year Treasury bonds declined 6 basis points.

The Ryan Index of 30 year Treasury bonds shows a return of 15.3% over the last year, while the Dow index rose 6.8%; stock investors would of course earned some income in addition, but it does tend to show bonds have been rewarding investors to a good degree.

Data reports recently have been on the lower figures. There are no really big changes for investors to focus on. For example, Consumer sentiment in July was down just a bit, and the ECRI leading index for 25 July was off 0.4 points reflecting, I expect, some slowing of the housing market. Vehicle sales slowed from 16.9 million units to 16.4 million (seasonally adjusted and annualized rates.)

On the favorable side personal income growth rose 0.4% in June. The ISM manufacturing index rose from 55.3 to 57.1, a healthy rise.

A more substantial change was made in construction spending which was off 1.8% month to month. This is the lowest figure in at least one year. The decline was seen in both public construction (-4.0%) and private (-1.0%) Residential construction was relatively less touched, off only 0.3%. Spending on single-family homes fell by 1.4%. Multi-family construction continued to move ahead at a higher rate, and investors and economists should calculate the reasons and the implications for consumer spending.

Year-to-date, stock investors have earned the most returns in technology and health care, however the income flow from utilities made them also very attractive to investors. The dollar strengthened against uncertainty and poor economic reports elsewhere. Negative real interest rates were for a time a feature of the U.S. “Great Recession “ but they were not especially effective in generating a cure. At any rate, today’s short term rates in the U.S. are once again below the rate of inflation, as they are in parts of Europe. Central bankers have not been notably successful in revitalizing stagnant economies, but they continue to try.

Our bond indicators remain strongly favorable. Bonds tend to do poorly when economies are booming and there is heavy demand for funds for expansion, therefore a forecast of strong bond markets suggests economic growth will be muted for at least a time and most likely minimal changes in the economic policies of the past. Equities could challenge investors, but a 50% decline such as we saw in 2008 is not likely. Recent bond and stock volatility have presented opportunities to purchase bonds at reasonable prices. We would continue to emphasize high quality bonds and moderate durations.

F James, Ph.D.