What happened in the stock/bond markets last week (10/13-10/17)?

Stock Market Analysis

It was another wild ride on Wall Street. The Dow Jones Industrial Average and the large-cap S&P 500 both lost approximately 1%. However, the small-cap Russell 2000, which has had a difficult 2014, actually gained over 2.7%. In this time of volatility, volume has surged. For the first time since November 2011 we have seen three days in a row where volume has topped one billion shares traded.

The volume is a sign of increased nervousness and uncertainty by investors. With the resurgence of small stocks and Friday’s rally for larger stocks some hope this is just a market dip that has created a buying opportunity. Others point to the eerily similar chart pattern of the 1987 Black Monday stock crash. What should an investor do?

It helps to look at the data. This week had a number of important economic releases. Some reports were positive such as the 1% growth in Industrial Production. However, much of the data was disquieting.

We note small business owners, as measured by the National Federation of Independent Businesses, are becoming more pessimistic. Most small business owners expect the economy to worsen instead of getting better. As approximately half of all jobs in the United States come from small businesses, this is an unsettling trend.

Housing is another important component to our nation’s economy. While at first blush the housing starts number appears healthy (growing over 6% last month) the underlying data tells a different tale. Starts on the more economically important single-family homes grew a meager 1.1%. The reason for the growth in the headline number came almost exclusively due to apartment starts which grew over 18% in the month.

Perhaps most worrisome was the decline in Retail Sales. Consumers comprise roughly 2/3rds of our nation’s economy. Recent data shows consumers pulling back on their spending. Some of this, such as lower spending at the gas pump, can be a good thing. However the picture in aggregate suggests reason for caution.

Overall our leading indicators are turning towards the unfavorable camp. This is different than our indicator picture in 1987. Back then our indicators were moving favorable and we expected a “waterfall” type of decline that would provide an amazing buying opportunity. Given our current indicator configuration it suggests risk levels are elevated and caution, not thrill seeking is the better course. We do note our long term indicators are favorable and we do not expect a 50% decline in stocks at this time. Still, today’s environment suggests investors should reduce equities in overinvested accounts.

David W. James, CFA

Bond Market Analysis

What a week!!! Talk about wide action! Prices broke down on the stock market. Fortunately, yields also declined in the bond market, thereby pushing bond prices higher. By week’s end, yields were down about 6 basis points on 2 year bonds. Additionally we saw yields fall 9 to 5 basis points on the 10 and 30 Year Treasury Bonds, respectively. The 30 year U.S. Treasury sells for yields below 3%. The center of the yield curve, 3 to 10 year bonds, got the best action last week. Commodity prices fell strongly, the promise of lower inflation supporting the rally in bond prices.

This bond action occurred about the same time that stocks were breaking. The SP 500 showed a decline of 9.8% from top to bottom. Thus the historical relationship once again proved true, the tendency for bonds to rise when stocks decline.

For months, we have suggested the desirability of higher quality, not “junk” bonds. The problem with holding lower quality bonds is noted by this quote from the 17 October Wall Street Journal: “Corporate bond investors have struggled this week to find trading partners for some large orders, causing unusual price drops and raising concerns that trading could freeze in future market turmoil.”

Our bond indicators are changing, now giving us different signals from the strongly bullish notes we earlier received and enjoyed. Might this be a reflection of a projected ending of the FED’s Quantitative Easing program, or perhaps it could be related to hidden elements strengthening the U.S. economy.

The perverse nature of the data is shown by this quote from Moody’s:

“U.S. housing starts rose more than expected for September, led by multifamily building. Apartment construction is positive but single-family building does more to support employment and GDP growth.” Others observe a one percent increase in single family housing starts is not the spark of a strong return. Single family permits, were reported down 0.5%, casting a shadow over the future.

We also note, on the negative side, the disappointing retail sales for September. Keen visual observers note apparent increases in sales and markdowns at certain large retailers. Add to a list of negatives is soft manufacturing, with NY Fed surveys said to be reporting the lowest reading in the past 7 months. Moody’s Business Confidence index peaked at the end of summer near 65 and recently was just above 50, still headed down.

Meanwhile, overseas the picture worsens. Margaret Thatcher once said: “The problem with socialism is that you eventually run out of other people’s money.” Are we nearing such a time? Industrial orders in Spain fell, capital goods orders were said to record a solid decline. Exports were soft in Germany, the leading exporter in Europe.

In the U.S. certain members of our FED group sometimes express concern that inflation is too low. We recall the 1980’s when Chairman Volcker and President Reagan endured a couple of stiff recessions amid money tightening to bring down the rate of inflation, recognizing it as an evil which undermines sound economies. Today some “experts” do not fear inflation. But inflation cheapens money and is a tax on the thrifty, the successful, and the savers. Does this furnish good incentives for a strong, successful society? As the FED longs for 2% inflation, members need to recall that even a “low” 2% inflation rate robs the saver of half the value of his thrift in only 34 years. And cheapening of currency is a break in faith with our citizens and those who have loaned us money.

While we have listed legitimate concerns above, the most important player in our economy happens to be the individual citizen and here evidence leads to the belief that the typical consumer may believe the economy is strengthening, and economic concerns are overblown. In fact, the University of Michigan Consumer Confidence survey, yet another sentiment report, notched its highest reading since 2007.

The President wishes to allay concern about Ebola. So far, it has disrupted travel and hospital receptions. But other concerns may arise which could impact U.S. commerce. Overall impact on U.S. GDP is likely to be negative, but bond prices may benefit.

Following large gyrations in equities and bonds, our indicators for stock are shifting from neutral to less favorable. Bond indicators, which were quite favorable, are also shifting and are now neutral, not favorable. This is not a signal to liquidate all bonds, rather to reduce durations and become more of a defensive player in the fixed income area.

F James, Ph.D.