Feb 22, 2016 - Here's what happened in the stock/bond markets last week

Stock Market Analysis

Last week stocks experienced a fine rally, with upward strength especially evident on Friday. For the week, nearly 3,600 stocks rose while fewer than 600 declined, with heavier volume on days with advances. Very bullish.

The latest pullback had seen nearly a 15% decline in the S&P 500 since the November peak. This has been labeled a “correction” rather than a “bear” since that label comes when stocks fall 20% or more.

After months of falling, we finally saw an upturn in the often accurate coincident / lagging ratio. Capital goods production has rebounded a little and home construction improved. Consumer expectations rose slightly, and so did Industrial Production after falling the previous three months. We are encouraged to see some improvements across the board, even if they are only modest in size.

The more significant question that needs to be asked is how much improvement can U.S. producers expect in view of declining global demand? Throughout the recovery since the 2007 financial crisis, the world’s central bankers have stimulated. Our own Federal Reserve System may have injected as much as $2.5 trillion to this cause. Other countries around the world found it easier to take on more debt, and they have done so with gusto, in some cases increasing debt to more than twice the size of the economy. This debt burden consumes resources that could otherwise be invested in growth. In spite of the best intentions of central bankers, the growth in demand remains suspect.

Many countries have reached the practical limit of interest rate reductions, and are now embarking on experiments with negative rates. China, the second largest economic power, has constrained trade and industrial activity while attempting to develop a consumption based economy. As a result, they have seen economic growth fall significantly. Chinese delinquent loans have increased by 51%, according to Barron’s. Of course, Chinese problems negatively impact their trade partners.

Another significant question deals with stock prices: Chances are it is not realistic to expect strong overseas demand to lead U.S. profits higher. But there are internal offsets, including some recovery in housing, strong auto sales, and caution on the part of investors. Furthermore, most industrial metal prices are also rising.

We believe stocks have been in a long term topping pattern. It is typical in these phases for prices to work toward higher regions, then to fall back into correction territory. Such a pattern could last many months, and right now our leading risk indicators suggest stocks are oversold, and we may see somewhat higher prices over the intermediate term, as we recover from the recent correction.

We are also encouraged by the apparent improvement in depressed “value” stocks. According to the Russell stocks classification system, in February, value stocks have started to outperform growth stocks. We now believe a modest increase in bargain value stocks is indicated, especially in issues which cater to domestic consumers.

F James, Ph.D.

Bond Market Analysis

The holiday shortened week saw yields on longer term bonds rise ever-so-slightly as the market digested a lot of economic data. Reports on everything from inflation, housing and industrial activity were released.

Of course, for most bond investors, one of the most important sets of data is inflation. Inflation is often the boogeyman as it eats away at the purchasing-power of a bond investment. Recently we have seen an uptick in inflation. The Consumer Price Index (CPI) has posted a year-over-year number of 1.4%. This is considerably higher than any of the readings taken in 2015. Still, it is well below historical norms. Over the last 30 years CPI typically grew at a 2.7% rate.

We also received mixed signals on the important housing sector. Mortgage applications have risen strongly in 5 of the last 6 weeks. However, much of this has been focused on refinancing mortgages rather than the more economically significant purchase of a home. Indeed, housing starts and permits both fell last month.

One economic bright spot was the gain in Industrial Production. Industrial Production is often considered one of the better monthly gauges of economic activity. The latest monthly rise is the best number we have seen since 2010.

Does this mean it is time for the economy to finally offer strong growth? Perhaps; unfortunately most of the major economic sectors have displayed disappointing results. Data from Bloomberg suggest most economic releases in areas like housing, industrial, personal spending and business surveys are substandard. Only in the labor market, on the back of recent job gains in manufacturing, are the numbers pleasantly surprising.

Overall our leading indicators are deteriorating slightly while still in the neutral camp. Given the strong positive movements in bond prices this year, a respite is not surprising. We would recommend maintaining a moderate duration at this time with a focus on higher quality issues.

David W. James, CFA

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