Stock & Bond Market Analyses (7/7 - 7/11)

Stock Market Analysis

Over the last two weeks stocks were especially volatile, at first rising and then, over the last five trading days, they began to fall on generally higher volume. Except for Wednesday and Friday, stock prices declined every day last week. On those two days where stocks rose it did so on lighter volume. For the week as a whole, 1173 stocks advanced against more than 2,000 declines. Overall volume rose in this declining week. The Dow Industrial average lost about 7/10s of one percent for the week, bringing its year to date return down to only +2.21%. Large stocks continue to outperform smaller issues.

To explain the declines analysts pointed to European problems encountered by the Socialists, including banking difficulties in Portugal (one bank missed an interest payment) and lagging industrial output in Italy.

Be that as it may, Socialists and economists who follow Keynes’ big government approach, both here and abroad, are searching to explain why, in the face of massive government action and stimulation, the economies continue to lag. In the United States, economic problems are especially manifested in poor full-time employment figures and in consumer spending.

How is it that well educated economists and government officials follow models which yield such disappointing results?

The “Procrustean approach” is an applicable term provided by my brainy granddaughter, Meg, referring to a Greek bandit who amputated limbs of travelers to fit his iron bed. She graduated from an Ivy League college with degrees in literature and liberal arts. I was not familiar with the term, having graduated from an engineering/technical school where I learned how to select securities in the stock market. But I had to agree with her. If one amputates or manipulates the model data enough, it will give support to almost any findings. Procrustean produced conformity by arbitrary means; perhaps economic data might have also been collected to fit a preconceived notion. Some years ago, Linda, another brainy associate, quoted her professor on this subject: “If you torture the data long enough it will confess.”

The Federal Reserve continues to forecast, along with most economists, “above trend economic growth” later this year. The failure of our economy to produce a strong recovery so far is now beginning to herald writers who focus more on incentives as the key to recoveries. In this line of thought, compensation paid to those who could, but do not work, may be appropriate for humanitarian reasons, but it can discourage working and it shows up in a low worker participation rate (those who seek employment), which, they note, is exactly what we find today.

How will future FED action impact the market? So far, stimulation and money creation has mostly helped the affluent who own real estate and stocks, it seems. The latest FED minutes talk of reducing its asset program (money printing, critics claim) to $15 billion a month and possibly ending after the October meeting.

The “Baltic Dry” Index of shipping costs fell again this last reported week, and is now off more than 60% year to date; suggesting declines in trade with China, our large trading partner. It is no surprise that new factory orders also lost ground. After rising to heights, public sentiment is pulling back a bit as stock prices decline.

A bullish feature about today’s stock market is investor sentiment, which is cautious. It remains suspicious of the rally. The short interest ratio, at 5.1 is near the five year high, lots of shares sold short. Also positive is the Investors’ Intelligence survey of professionals which shows increased pessimism.

Prior to significant declines, it is typical for large stocks to outperform, also for volume to increase on declines. “Bargain” stocks (deep value issues) hold up best in major declines. These factors are present today. Our intermediate leading indicators are weakening, however so far they do not suggest a major bear decline (20% to 50%) is imminent. Of course, this could change. We would not be surprised at a lesser pullback in stock prices, and would suggest a cautious approach in equities at this time.

F James, Ph.D.

Bond Market Analysis

Conclusions: The bond market’s unexpected journey continues as interest rates once again fell for the week. Our suggestion that 2014 would be the year of the bond continues to be on the mark. For the week the 10 Year U.S. Treasury yield fell from 2.65% down to 2.53%.

Of course as yields fall it signals higher bond prices. This has been especially welcome on longer dated bonds. In 2014, we find Treasuries maturing in 20 or more years have advanced over 13% on a total return basis. This is nearly 10% higher than the Dow Jones Industrial Average; a popular stock index.

Again, for most analysts, this is a highly unexpected journey. The playbook for most economists is for increasing yields for the year, not declining ones. Indeed, the latest survey from Bloomberg News shows economists remain stuck singing the same chorus over and over again. Their expectations are for sharply higher yields by the end of the third quarter and then higher yields for each of the next six quarters following. As contrarians this suggests bond investors have a “wall of worry” opportunity.

Why do so many analysts continue to expect the worst for bonds? One reason may be the Fed’s tapering policy. Under Quantitative Easing (QE) the markets expect the Federal Reserve to come in every month and buy massive amounts of bonds. The theory goes that as the Fed tapers they are not buying as many bonds and eventually will quit buying bonds altogether. Analysts fear as this occurs the lack of a natural buyer will cause bond prices to fall.

The chief problem with this theory is it ignores all other market participants. With the Fed buying bonds it generally causes other market participants to seek investments in higher risk vehicles. When the Fed backs away it causes investors to re-examine the market’s risk profile and many investors return to the safer confines of the bond market; especially higher quality bonds like Treasuries.

History has shown this to be the case. In the period between QE-1 and QE-2 the Fed was not actively buying bonds. How did the debt instruments perform? Long bonds gained 13.7%. Between QE-2 and QE-3 these bonds advanced a staggering 26.0% return. Now, during the tapering period, these bonds have advanced 12.8%. It seems when the Fed goes away bonds will play.

It is also true bonds usually react in opposite fashion to the economy. Once again we see economists expecting robust growth for the 2nd quarter and beyond. How likely is this to happen? It is true some areas are promising. New orders for manufacturing seem to be positive and automotive sales are strong. However there are other cautionary signs. Shipping costs, as measured by the Baltic Dry Index, are off an incredible 64% this year. This suggests a lacking need of economic activity.

Employment is also a factor. Although total jobs increased nicely in June, a disturbing truth lies just under the headlines. Namely, we lost over half a million full-time jobs for the month. Full time jobs matter for the economy. In fact calendar quarters that end on similar sour employment notes usually mark sub-par GDP growth. While we do expect 2nd quarter GDP to be better than the 1st quarter numbers it seems likely that many analysts will likely be disappointed in the results and this could continue to help the bond market’s cause.

Presently our indicators for bonds are favorable. Obviously, swings in bond yields will naturally occur. However, the recent unraveling with a major Portuguese bank last week shows the benefits of staying with higher quality bonds. We would recommend staying with higher quality bonds and maintaining good duration levels.

David W. James, CFA

 

Really informing post thank you. Do you think that bond prices will change due to Yellen's continuation of low interest rates, ie will this have any influence on price fluctuation and volatility?

"Everyone has a plan until they get punched in the face."
 

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