Stock Market Analysis
Meh. The Dow was up slightly while most other averages were down or flat. Rising stocks were pretty evenly matched with falling stocks. However, several indices got close to record levels and this was reflected in the number of new highs as we saw 513 new highs to only 37 new lows. The market started the week strong but had a headwind coming from Europe and the upcoming exit vote from the United Kingdom.
The market’s inability to hit new highs is reflective of the Doldrums Market of the last 18 months. Since the end of 2014, the Dow and S&P 500 are almost unchanged. We have seen prices fluctuate, but the fluctuations have been much lower than normal. David James, our Director of Research, did a historical study of this phenomenon. Here is what he found.
Looking at the Dow Jones Industrial Average from 1900 (on a rolling 18 month basis), the month end high has typically been 30% higher than the lowest month end low during that period. However, there are times when the market is in the doldrums. These occur when the high-low spread is only 12% or less. These happen infrequently, only 34 times out of 1,357 observations.
We found bad news and good news: First, the bad news. After one of the rare doldrums events, stocks did below normal in the next six months, averaging gains of only 2.0%. The good news, in the 18 months following the doldrums, stocks averaged gains of 17.7%, which is higher than usual.
Our monthly research reveals another disturbing trend; the market has been rewarding lower quality and underperforming stocks. Research Associate and Portfolio Manager Trent Dysert did an analysis of the last three months. He discovered the lowest quality stocks, by our measures of value, earnings and price strength, did three times better than the highest quality stocks. In addition, those stocks which had been the poorest performers in the last year had about twice the return of the stocks which had been outperforming in the last year. This is the fourth month in a row of the dogs outperforming. Going back to 2000, our research shows this is highly unusual, as it has only happened twice in that time frame. The last time it happened in 2006, saw this trend reverse sharply over the next twelve months and high strength stocks outperformed.
Now that we have presumptive nominees for president, the election is starting to dominate investor’s thoughts. As we pointed out in our Economic Outlook, the lame duck year of a two term president usually sees losses, so struggles this year are normal. At this point, the markets will try to anticipate a winner and adjust prices accordingly, so we are releasing a white paper called Who Will Win? We discuss the current outlook and the impact the candidates may have on various investments.
Currently we see Donald Trump's inexperience and temperament causing him problems. In addition, the media is exercising a level of scrutiny and issuing negative reports it didn’t in the primaries. If this narrative continues, Hillary Clinton would likely win and the markets will start to discount her actions as President. Her stated positions appear to be a continuation of many of President Obama’s economic policies – trying to bring about more fairness through higher taxes, higher spending, and more regulations. The markets will use the last seven years to extrapolate her impact on future economic growth and inequality.
Bond Market Analysis
A good week for bonds. Long treasuries rose 1.3% and are now up over 12% this year. Corporate and municipal bonds also did well. Munis were helped with the passage of a Debt Relief bill for Puerto Rico. It had bipartisan support and the President also is in favor. This is important because Puerto Rico is about to default on more of their $70 billion of debt.
Bonds have rallied off their April lows as economic reports show little acceleration. Last week consumer spending grew less than expected and consumer credit was also subdued. This could be a result of poorer labor markets than hoped. In addition to a weak jobs report the week before, the Fed’s Labor Conditions Index fell to the lowest level since May of 2009. The previous report was also revised downward.
The Fed had been jawboning about raising rates but the futures market now puts it at less than a 2% chance in June. These poor labor conditions do not favor a hike, especially with inflation holding steady at modest levels. Janet Yellen even said she is focused on job creation, which means she isn’t looking to raise rates until economic conditions substantiate such a move.
We have seen corporate profits dwindling over the past year and the first quarter productivity report isn’t encouraging. Productivity dropped by 0.6% and unit labor costs jumped by 4.5%. This eats into profits and is also a sign companies are not being effective in finding ways to enhance productivity.
Our indicators are somewhat favorable, and we had seen the 30 year bond yields remain in about a half percent trading range for some time. We are at the bottom of the range and are likely to see rates stabilize unless external events overwhelm the market. While we would maintain a posture of moderate duration with high quality bonds we would still advise taking a barbell approach. Using a barbell, investors usually focus on short term and longer term bonds. The short term bonds provide stability while longer term bonds are usually more sympathetic to the future of the economy.
Barry R. James, CFA, CIC
