Stock & Bond Market Analyses (10/6 - 10/10)

Stock Market Analysis

Another week of volatile stocks and another week of market decline. The Dow lost 465 points, about 2.7%, on heavier volume while the S&P 500 declined 3.1%, more than 61 points. Year to date, the Dow is up a lowly 1.6% on a total return basis. Smaller stocks were recently hit harder, with the Russell 2000 falling 4.6% or 51 points for the week and 8.6% year to date.

The worst performing sector for the year is energy, but copper is also in a sharp retreat, dropping 6 or 7 percent. It seems general deflation of financial and commodity prices are underway.

Stocks have been moving lower in spite of strength in the dollar. The US dollar index (DX) has risen 6.8% this year, which may impact earning’s growth in the future if this continues.

Since peaking on September 19, the S&P 500 is off 5.1% and is now at approximately the same level, (index value of 1906), as they were at the low point of the July- August correction, which was 1904. Should prices break much more, chartists will be tempted to dump stocks, which could lead to a sharper if perhaps temporary break.

Newsletter optimism for stocks appear to have peaked in September, II (Investors Intelligence) Bulls – Bears topped at 43.5%. That has very gradually declined to 31.4% last week, which is about normal for the start of bearish trends. Earlier weeks found pessimism rising very quickly, suggesting to us a limited downside follow through; no bear market. Trader sentiment shows the same pattern. A gradual buildup in negativism, but at a very measured rate, somewhat less than expected with the sharp price breaks we recently sustained. There is too much optimism. Recently, we reported more than 11 “buy” recommendations per “sell” recommendations by Wall Street analysts; a well-intentioned crowd who have nevertheless been less than successful in the past.

New negatives for the U.S: Our trading partners in Europe are said by EC Bank leader Draghi to be considering quantitative easing. Should this be no more productive than the U.S. version, it will do little to enhance trade. Also of concern is the news that the European Central Bank head is studying the use of the Chinese Yuan as a reserve currency. Should this occur in the future, our FED might begin to lose its freedom of action and would have to more carefully consider “printing” of money and expanding credit.

We have not discussed prospects for earnings. The reason is that stock markets have ignored hesitant earnings on the way to all-time highs, and strong earnings today might do little more than pave the way for declines. Old traders would sometimes say, “Tops are made on good earnings news, bottoms the reverse.”

Momentum indicators, such as the stochastic, MACD, and the 21-day Bolinger Band, are issuing “sell” signals. Smaller stocks, which sometimes lead on the downside, are especially weak. In fact, about 61% are already in bear markets; down 20% or more from peak. Our encouragement is the position of our short term indicators, which are finally strong. Also, our intermediate term leading indicators remain mostly neutral, suggesting low odds of another ’08 type decline.

What does it all mean? We do not recommend being overinvested in stocks and would maintain a conservative posture until we get better risk readings. We earlier wrote to clients, suggesting that a “”modest” position in equities was best. That conservative approach continues to be appropriate for most portfolios.

F James, Ph.D.

Bond Market Analysis

2014 continues to be “The Year Of The Bond”. So far this year, the longer-term bonds in sectors like Treasuries, higher grade corporates and municipals (Government Obligation or GO) have all made over 13% returns. By comparison, the Dow Jones Industrial Average is up just 1.6%. Higher quality bonds or longer maturities have clearly dominated.

The popular refrain by Wall Street pundits throughout the year has been, “Yields cannot go lower, and they must rise.” Has the popular opinion finally changed? No. The most recent survey of economists by Bloomberg News suggests the “experts” believe the yield on the 10-Year Treasury will dramatically rise by nearly 40 basis points by year’s end. Given the track record of these “experts”, the contrarian investor should continue favoring bonds.

Another reason favoring bonds is their competitive position. All else being equal, investors prefer a higher yield for a given level of risk. When we compare the yields on 10-Year US Treasuries versus similar yields on government bonds for developed countries like Canada, United Kingdom, France, Germany and Japan, we find the US has the highest yield.

Not only do we have comparatively higher yields, but our currency is in ascendancy. Since the end of June, the US Dollar is up over 6% and 8% against the Japanese Yen and the Euro, respectively. A strengthening dollar can help boost the total return foreign investors receive by placing their money in our bonds.

Domestic investors are also looking at bonds thanks to the expected ending of Quantitative Easing (QE) in October. The Federal Reserve’s QE programs essentially have pushed investors into seeking higher risk assets, such as stocks, to the detriment of safer investment vehicles, including bonds. During periods of full blown QE, the 10 and 30-Year Treasuries returned an annualized -3.1% and -8.8%, respectively. However, in periods of no QE or Tapering, investors reexamine their risk profiles and return to the fixed-income arena. During these times, the 10 and 30-Year Treasuries have gained an impressive annualized 14.4% and 26.5%, respectively.

For certain, no market goes straight up or straight down. That being said, we note our leading bond indicators remain in the favorable camp. If we do see a short-term back-up in yields it may provide another buying opportunity. For now, we recommend maintaining moderate to long durations in high quality bonds.

David W. James, CFA

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