Dec 31, 2013 - Stock & Bond Market Update

Stock Market Analysis

Christmas is a time of giving and the markets gave a great gift last week. The Dow hit new all-time highs and rose 1.6% while the small cap Russell 2000 rose 1.3%. Let’s take a closer look at these wonderful presents. The Dow has risen about 26% this year, making it the best year since 2003. This wasn’t even the best performing stock index, the S&P 500 rose over 29% and the Russell 2000 topped that with a 36.7% gain. The Dow Internet index rose an even more impressive 53.1%

This is indicative of investor appetite for risk and is further evidenced in the Initial Public Offering (IPO) arena. Bloomberg tracks IPO performance and it reports returns in excess of 60% this year. This is especially unusual since our research shows IPO’s actually tend to lose money their first year. We’ve seen a huge new supply in 2013 with over $55 billion in new shares issued, the best since 2000. Companies realize stock financing is extremely cheap as valuations are extended and interest rates are still low. What does this say about the coming year?

As we saw in 2000, a large increase in the supply of stock can be an indication of excess enthusiasm and a topping market. We see other indications of this as well. The value of the stock market is in excess of the annual production of our country. Stocks usually falter when this occurs. Other valuation measures, both from Schiller and from Fama show prices at excessive levels but pundits are quick to point out their work was wrong for 2013. We are also concerned with the extreme level of margin debt, which is borrowing to buy stocks. We have reached record levels and the last two peaks in margin debt were 2000 and 2007. Lastly, bullish sentiment has reached extreme levels. The vast majority are bullish, and I was even chided on CNBC for being worried about a correction.

While conditions are ripe for a correction, the momentum of the market is obviously helping sustain the monster rally. We have seen a shift in investor appetite toward stocks after they had abandoned them in 2012. Amazingly, this wasn’t affected much by the Fed announcement of tapering. Our indicators remain in a neutral configuration and this is seasonally a good time for stocks. We would trim back equities in overinvested accounts, but would wait for further confirmation from our indicators before cutting equity levels again.

Barry R. James, CFA, CIC

Bond Market Analysis

Bonds had a woeful week and delivered coal for Christmas. Rates jumped across the yield curve, both long and short term rates rose. Long treasuries lost 1.8% and intermediate term treasuries lost 0.2%. Almost all other bond sectors lost money except for high yield bonds, which only eked out a gain of 0.1%. In the other good news of the week, Municipal bonds didn’t lose money, however, they didn’t make any either.

This has been the worst year for bonds in my professional career. Long treasury bonds have had double digit losses and only high yield bonds have resisted the pain of the downturn. Stock euphoria and modest economic improvement have shaken the bond market. Worries about the Fed tapering program had translated into the biggest part of the pullback in bonds, and now it seems that the actual tapering isn’t boosting confidence. However, we have seen bonds rally when Quantitative easing actually ends. Unfortunately, at the current pace, the Fed won’t end the program until the second half of 2014.

We still think it is important to continue to hold bonds in balanced accounts. First, they will likely offer safety when the inevitable stock market correction comes. They also offer insurance if the economy takes an unexpected tumble. Lastly they provide liquidity and income. However, it is important to try and wisely manage bonds as we go through a transition period, from falling to rising rates. This entails diversifying across the bond market and owning bonds with higher yields than treasuries. It also means holding bonds of lower duration. We have made these changes and will monitor our indicators for signs we should do even more.

Bonds have over reacted and are oversold. But of course, they can get even more oversold. While some economic indicators, from GDP to Industrial Production and Productivity point to solid economic growth, we don’t see any real signs of inflation heating up. Both the Consumer Price Index and Producer Price index show inflation is well contained. In addition, the Personal Consumer Expenditure measure is equally contained. Demand isn’t heating up, except for a few products, like homes. Our intermediate term indicators are positive, and they point to a likelihood of a rally in bonds, even if it isn’t permanent. We would maintain modest durations in high quality bonds.

Barry R. James, CFA, CIC

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