Stock Market Analysis
How do you like me now?! The country song was number one for five weeks and we’d all like to see another 4 weeks like this last one. In spite of the terrorist attacks in Paris and Mali, the Dow rose 3.48 percent and the Russell 2000 rose 2.52 percent. We had twice as many stocks rise as fall, but new lows swamped new highs. From a technical basis, the market has been unable to push through recent highs and the Arms Index reveals more action in falling rather than rising stocks. Amidst this confusion, how does one answer the question, “How do you like me now?!”
This question is especially valid in looking at the difference between expensive and bargain stocks. Unfortunately, most approach using the terms growth or value, but those are typically arbitrary constraints that merely focus on one or two criteria. In the case of the S&P Barra Indices, the only rule was Price to Book. The bottom half of the stocks in the index were value and the other half was growth. At times this arbitrary cut off made no sense, as the “value” stocks had higher PE ratios than the “growth” stocks. That is why we talk about expensive and bargain stocks.
For us, a stock is a bargain when it is trading at valuation levels cheaper than the universe of available stocks. However, for it to be a bargain, it also should have historical earnings growing better than the universe as well. Lastly, the only true bargains are those with a high probability of making you money. Therefore, we also want to see the price of the stock rising at a pace that exceeds the universe. This approach, while disciplined, goes through periods of outperformance and underperformance. While not as severe as the late 90’s, thanks to quantitative easing, we’ve seen a period where expensive stocks have been outperforming bargain stocks. However, in October, we saw what we hope is the start of a key reversal. We saw the top rated bargain stocks crush the most expensive stocks by more than 20%. However, one month does not a trend make, but we do believe this is a coming attraction.
The markets have had the crutch of quantitative easing removed and investors are trying to figure out the real potential of stocks. As we had mentioned in our 2015 Economic Outlook, “It may well be a year of greater volatility, but active management could be a key to generating positive returns.” Indeed, the year has been more volatile, and stocks haven’t produced stellar returns. Part of the problem has been the global slowdown, the strong dollar and falling sales and earnings. Among S&P 500 stocks, about 40% of their earnings come from abroad, so it is of little surprise we have seen 2 quarters in a row of negative earnings growth. While overall earnings are pretty high, the trend hasn’t been going the right way.
Our indicators only point to modest risk in the next few months. While no approach is foolproof, this means only a 20-40% chance of a significant drop, with the odds favoring a modest advance. This doesn’t mean the market won’t undergo some trouble in 2016, it just means we wouldn’t abandon our modest equity levels at this time. To twist a phrase - modesty is currently the best policy.
Barry R. James, CFA, CIC
Bond Market Analysis
Bonds rallied even as stocks did as well. Longer term treasuries gained 0.7 percent while muni bonds did even better. Every sector of the bond market, except high yield, had gains for the week. Longer term yields fell more than shorter term yields, so the yield curve flattened a little.
The Fed released its minutes from the October meeting and said they saw economic activity expanding moderately and they thought underutilization of labor resources had diminished. They also talked about the lifting of rates and suggested the expected path of policy would be more important than the timing of the first hike. Nonetheless, they noted, “... that beginning the normalization process relatively soon would make it more likely that the policy trajectory after liftoff would be shallow.” More than anything else, the bond market took solace in the word “shallow” and also some discussions of limiting eventual hikes to a lower level than expected.
Economic reports haven’t been encouraging. The Empire State manufacturing survey was decidedly negative and well below consensus expectations. This is in keeping with the report on Industrial Production, which fell in October. This has been the case in 7 of 10 reports this year. However, the manufacturing component rose while utility and mining slipped. The housing market seems to be slowing a little, but traffic remains strong, rates are low and homes are fairly affordable.
All in all, consumers have lowered their debt service payments to the lowest since the 80’s and they have seen some improvements in jobs, hours and wages. There hasn’t been a lot of improvement, but there has been improvement. Still, retail sales haven’t been rising much even though consumer sentiment readings have been firm. To really tell what the consumer is doing, we need only look at the velocity of money. It gives a read on how many times a dollar is rotating through the economy. If consumers are really optimistic, we will see money turn over a lot. It is at a 40 year low and heading lower, showing the conservative nature of consumers today.
Last week we noted that bonds often respond positively to a crisis. We said, “It would not be surprising to see our Treasury market rally in the very short term.” Indeed, they did rally and as we look at our leading bond indicators, they remain slightly favorable today. We would continue holding higher quality bonds of moderate duration at this time.
Barry R. James, CFA, CIC
