Stock & Bond Market Analyses (5/12 - 5/16)

Stock Market Analysis

Conclusions: It was an uninspiring week on Wall Street. The S&P 500, on a total return basis, barely etched out a 0.03% gain. Smaller issues, like those of the Russell 2000 were not as fortunate and declined 0.34%.

Indeed, this is simply continuing the trends we have seen so far in 2014. It is said that a bear market occurs when the market is down by 20% or more from its high and a correction is at least a 10% decline. What happens when we look at this on an individual stock level as opposed to the popular indexes? Today, we would find only 6% of the individual stocks comprising of the large-cap S&P 500 in bear market territory and another 18% are in correction mode. Smaller stocks (those sized between $500 million and $3.5 billion) are faring much worse. Today approximately 25% of small stocks are in their own personal bear market with another 27% suffering a correction.

There have been some interesting developments within the stock market. Each month we perform a three month analysis to better understand the forces impacting the stock market. This last three months saw a return of value investing. Factors like Price/Earnings and Price/Book returned to normalcy with cheaper securities outperforming their more expensive brethren. This is good news for traditional bargain investors.

One growing concern for corporations is the difference between their cost increases and higher payments they can charge their customers. Our research department tracks this using the inflation differential: the difference between the Producer Price Index (PPI) and Consumer Price Index (CPI) on a Year-Over-Year basis.

We use the wholesale inflation (PPI) as a proxy for cost increases a business must face. Likewise the retail inflation (CPI) can offer insights into how much more businesses are increasing their prices to their customers. Presently the PPI is running over 1% faster than the CPI, a considerably higher rate. This suggests profit growth may get squeezed in the future and this is historically problematic for stock returns.

Overall our leading stock indicators are improved from their readings a few months ago. However, they have yet to give us an all-clear signal. Given the continued turmoil in the Ukraine and slower-than-expected economic activity we would continue to remain cautious at this time.

David W. James, CFA

Bond Market Analysis

Conclusions: It was a good week for longer term bonds. The 10 and 30 Year Treasury bond yields fell 10 and 13 basis points, respectively. So far this year the longer term Treasury bonds have advanced over 11.6%, far outpacing many of the popular stock indexes.

As a contrarian it is interesting to note how many bond pessimists remain. Bloomberg surveys 70 economists every month to get their projections on yield movements for the 10 Year Treasury. Presently, with the 2nd quarter approximately half way finished, we find the 10 Year Treasury yielding 2.52%. Yet for every one economist that believes we can end the quarter around these levels there are eight that are convinced yields will end the quarter at a 3% or higher yield. Given economists track record on yield forecasting bond investors should feel more confident.

It is also important to remember that bond prices and the economy often move in different directions. This week’s economic releases left some holes in pundits’ theories that any economic slowdown was simply a case of the bad weather of the first quarter.

Industrial Production is arguably the best monthly gauge for the U.S. economy. It has a strong correlation to GDP. We find that April saw Industrial Production fall 0.6%. Perhaps the pundits would like to blame this on the balmy spring weather?

Neither are the signs of economic sluggishness relegated to Industrial Production. It is known that approximately 2/3rds of our nation’s economy comes from the consumer. Perhaps the best information on consumer action comes from retail sales. Here the advancement was an underwhelming 0.1%. Further, if one backs out automobiles and gasoline we note sales actually declined.

Not all economic data is negative. Small business owners surveyed by the National Federation of Independent Businesses (NFIB) showed the most optimism since 2007. It should be noted, however, that most of these small business owners still see negative trends ahead for the economy. Worse, when these owners were surveyed on their biggest problem items like workforce, competition and poor sales could not crack the top two responses. Those belonged to taxes being too high and too many regulations. If Washington wants a better economy they must learn from the wisdom of Pogo, “We have met the enemy and he is us.”

Presently our leading bond indicators are neutral. The best time to purchase long-dated bonds is probably behind us. We are reminded that bond investments in this environment, much like stock investing, needs an active approach and not a buy-and-hold-forever philosophy. Still in the current environment we would continue recommend holding a good position in high quality bonds.

David W. James, CFA