What happened in the stock/bond markets last week (5/13-5/17)

Stock Market Analysis

Conclusions: The Dow and the S&P 500 hit new record highs last week. The Dow surged 1.6% while the S&P jumped 2%. The excitement extended to small cap stocks as well. In spite of the big jump in the indexes, only 19 stocks advanced for every 13 stocks that fell, however, 914 stocks hit new highs and only 74 hit new lows. In the words of Phil Robertson, everybody (but the bears) was “Happy, happy, happy.”

It seems as if the Fed will keep buying bonds forever. They continue to buy $85 billion a month and this makes it very difficult for folks to stay in bank or money market accounts. Our research reveals stocks have risen at a 20% + rate during periods of quantitative easing. The stock market did pull back a bit on the day one of the Fed governors suggested they may stop buying bonds if conditions improve. However, it didn’t last. The big winners on the week were financial stocks, much like we have seen throughout the year. As we pointed out in our December Economic Outlook, financial companies can borrow very inexpensively and they are making very strong profits on the high margins.

Enthusiasm continues to grow. Many sentiment polls have bullish readings of 70% or higher. Barron’s quotes Steve Sosnick, “It’s increasingly hard to come up with the next worry that could derail the market.” I experienced the same attitude when I was on CNBC the previous Friday. I literally could not get a word in edgewise with the hyper bulls. They saw nothing but blue skies and stock prices rising for the foreseeable future. I hope they are right, but our Risk Exposure Ratio says the risk of a significant correction is better than three in four. Momentum mitigates an immediate collapse in stock prices, but risks are rising.

Earnings are weak. The first quarter has only seen a 2.1% increase in earning while revenues actually fell. Valuation levels are not low. The S&P 500 is running a 19.3 PE while the average PE is over 25. Yields are low and stocks are running at 2.5 times book value. Even if the economy improves, it is hard to see how it could help the market any more than is anticipated.

We don’t really see much change in our indicators. Although we don’t yet find evidence that stock prices are at a peak and must decline immediately, risk levels are elevated. A cautionary path is advisable. Market tops are often notoriously long lived and this one will likely be no exception. Investors might use this time to upgrade portfolios, weeding out stocks which have not kept up with the market and replacing them with more promising issues.

Barry R. James, CFA, CIC

Bond Market Analysis

Conclusions: Bonds are pulling back at about the same pace as the stock market is rising. Every major sector of the bond market fell last week. Long term treasuries fell 1 percent. Year to date, only High Yield bonds have had decent returns, with most sectors of the bond market losing ground.

Inflation certainly isn’t a problem. Both the Producer Price Index and Consumer Price Index fell last month and yearly readings are a measly 0.6% and 1.1%. We also saw import and export prices fall in the latest report. Commodity prices are often used to project inflation and they aren’t showing much inflation either. Last week, Gold fell 5% and Silver fell 5.5%. This year they have fallen respectively 18.5% and 26%. While the Leading Economic Indicator improved nicely, a better predictor of the economy, Industrial Production fell more than expected.

We’ve been watching the Four Horsemen of the Economic Apocalypse carefully for clues about the economy. This indicator is composed of four reports from the Federal Reserve. Look at the results in the table below. It shows the number of the reports that are negative and what economic activity has been like in the next six months. Currently all four are negative but we have more reports coming out this week.

Horsemen......Industl Production Growth....Occurrences of a CONTRACTION
0 or 1..........................+1.50%.............................10%
2................................+1.12%.............................11%
3.................................-0.53%.............................33%
4.................................-2.76%.............................60%

In the end, bonds will reflect inflation expectations and economic activity. Our indicators are positive and we would use the current pull back in bonds to buy bonds for portfolios that need to get up to our target duration.

Barry R. James, CFA, CIC