Stock Market Analysis
It was a positive week on Wall Street. Larger issues like those showcased in the S&P 500 advanced 1.8% while the smaller stocks of the Russell 2000 gained an impressive 3.6%. Advancing securities outpaced decliners by a 3-to-2 margin on lighter-than-normal volume. Headlining the advance were Non-Cyclical and Technology issues while Energy lagged.
The overall first quarter was certainly an interesting one. On a percentage basis this was the worst January since 2009. Similarly, the strong rally enjoyed in March was the best one for that month since 2009 as well.
What will come next? Long term we have some concerns. Valuation methods are often imperfect in offering tactical guidance, but their track record in strategic thinking is usually valid. One such method is Cyclically Adjusted Price-to-Earnings or CAPE. CAPE, developed by the academic Shiller, compares today’s stock price versus earnings over the long-term.
Our research examined the CAPE data from 1929 through today. We then compared it to future 5-year stock returns. Our findings? Low CAPE values (17 or less) are generally associated with above average returns over the next five years. However, high CAPE readings (24 or more) typically see negative returns for stocks over the next five years. The most recent reading for CAPE is a disquieting 26.2.
While the high CAPE level suggestions caution for the next few years, it does not mean stock investors should give up hope. Instead, it simply suggests investors should focus on counter punching tactics; adding equities when intermediate risk levels are low and reducing equities as risks elevate.
Within this environment it is advantageous to think like a contrarian. To this point, we note the public has a growing level of optimism. Professional investors, like those surveyed by Investors Intelligence, have thrown off their bearish thinking and have increasingly become believers again.
Further public optimism comes with Fed Chair Janet Yellen’s dovish comments, which lead investors to believe rate hikes in 2016 will be more limited than originally thought. When Yellen’s remarks are combined with Friday’s strong non-farm payroll jobs report, it becomes easy to understand why pundits are excited about the market’s future.
It is that very public excitement that gives us pause in search of deeper clues. One clue comes from examining the type of jobs created. While job creation is a good thing, not all jobs are created equally. When examining the breakdown of high versus low wage jobs we note a disturbing situation. Last month 95,000 low wage jobs were created while the economy lost 13,000 high paying jobs. Another report suggests a growing number of Americans are finding a job is hard to get. The country’s job growth may be real but it does not seem to be satisfying.
An additional concern is the overall state of the economy. One of the better forecasting systems for economic growth comes from the Atlanta Fed and their quantitative GDPNow report. This report has been mostly trending southward since mid-February and their current prediction for GDP growth in the first quarter is for a disappointing 0.7%.
As we tune into our indicators, we note their positive surge in February correctly predicted the current rally. However, they are now waning and are no better than neutral today. Further upside is possible but risk levels are rising. We would recommend holding off on any aggressive buying at this time.
David W. James, CFA
Bond Market Analysis
It was a great week and a great quarter for U.S. Treasury bond investors. Last week U.S. Treasury bond prices increased as yields declined. The 2-Year U.S. Treasury bond declined 13 basis points and the 30-Year U.S. Treasury bond declined 5 basis points. The Bloomberg U.S. Treasury Index rose over 3% during the quarter which was its strongest quarterly performance in years. Long Term U.S. Treasury bonds were up over 8%.
Lower quality (high-yield) bonds were down almost 6% at one point during the quarter but rallied back to end the quarter up over 2% on a total-return basis. Investment grade U.S. Corporate bonds provided investors with returns over 4% and those bond prices were much less volatile compared to lower quality bonds.
Foreign bond investors also saw strong returns during the quarter but most of their total-return came from a weakening U.S. Dollar. For example, including foreign currency returns, Japanese bonds were up around 12%, Canadian bonds were up around 9%, and German bonds were up around 9%. With absolute starting yields extremely low in Japan and Germany, it does not take much to produce large gains and large losses.
The Atlanta Fed has developed a forecasting tool to predict U.S. GDP called GDPNow. GDPNow currently suggests first-quarter 2016 economic growth has declined to 0.7%. Just two weeks ago it predicted 1.4% growth, but poor consumer spending and export data released this past week reduced their estimate.
While Initial Jobless claims were disappointing last week at 276,000, other economic reports were better than expected. The Chicago PMI increased to 53.6 (above 50 = expansion) and the Case-Shiller home price index rose to a year over year rate of 5.75%.
Portland, Seattle, San Francisco, and Denver all saw home prices increase by more than 10% in the past year. These increases brought prices in the first three cities above their peak prices reached during the halcyon 2006-2007 time frame. No inflation here! Of course, the Fed did not “see” the home price inflation from the last housing bubble either.
By one measure, the Fed is providing more economic “accommodation” now than it was during the financial crisis. The Taylor Rule, which uses inflation and unemployment to prescribe an appropriate Fed Funds Rate, is currently prescribing a policy rate of 3.6% while the official Fed Funds Rate upper bound is 0.50%. This 3.1% difference is the biggest divergence in over 30 years.
Low energy prices were one of the positive factors we cited in our 2016 economic outlook. U.S. consumers are taking advantage of this by purchasing more gasoline and less gas efficient vehicles. U.S. gasoline demand reached record levels in March which is unusual since demand records are usually set in the summer, during the peak driving season. Free markets usually correct the supply/demand imbalances as lower prices beget higher demand.
Overall we note a neutral picture in our bond indicators. For now we would maintain a position in higher quality bonds while maintaining a moderate duration.
Matt Watson, CFA, CPA
