3/5/12 Market Commentary by James Investment Research

Stock Market Analysis

Conclusions: By a narrow margin it was an up week for stocks as more securities advanced than declined. However, it was anything but a uniform advance. Larger securities like those in the S&P 500 advanced 0.2% while their smaller brethren fell 0.1%.

Further, there are growing signs of caution. The timing of traders’ actions offers important clues. Trades done in the earliest part of the day are usually performed by the most speculative and emotional traders and their direction should usually be avoided. However, the smart traders often make their presence felt at the very end of the trading day. Last week the speculative traders pushed the Dow Jones Industrial Average higher by over 140 points. The smart traders? They pushed the Dow southward by over 140 points.

Volume also provides unique insights. It can be said that volume actually measures the conviction level of traders. Over the last three weeks volume has been, on average, over 180 million shares heavier on the down days; a disquieting trend.

However much of this data, while important, is technical in nature. The bigger concern is what corporate insiders are doing with their own monies. TrimTabs recently reported that, for the month, insiders sold an astonishing 50 shares for every 1 share they bought; a record according to their data.

There is also a difference in the public’s mind over governmental shenanigans. Last year’s “Fiscal Cliff” was met with high anxiety. Our indicators at the time suggested the pessimism was overdone and was creating a wall of worry for the market to rally on. However the sequestration situation did not cause the same level of angst and a new “worry wall” is missing.

Would government cuts in spending have any dynamic effects on the economy? History suggests the answer is a surprising yes. It is surprising because cuts in government spending have often been harbingers to better economic times ahead. Calvin Coolidge discovered this back in the 1920s when he, his Treasury Secretary Andrew Mellon, and his Budget Director Herbert Lord cut government largesse and ushered in an economic boom we now call the roaring 20’s.

Our research suggests this was not a one-time event. Going back to the 1940s we find quarters where government spending fell were followed with the next year’s economic gains averaging an impressive 5% (with a normal year’s economic growth averaging 3.2%). Similarly when the government tried to lead the economy to victory by increasing their spending by 2% or more the economic results for the next year were a sub-par 2.7%. The old joke of the most dangerous words is “I’m from the government and I’m here to help” seem apt.

Certainly certain areas of the nation will feel negative effects from a pull-back. Washington D.C. may be chief among these as will areas heavily reliant on government employment such as military bases which use a number of civilian contractors. However for the nation as a whole we may benefit from a smaller government footprint. Alas, expectations of true long-term cuts in the government are unfortunately quite low.

Regarding stocks we obviously have concerns. However most market tops can take a surprising amount of time to complete. Our indicators, so positive towards the end of last year, are now in the neutral camp. As we mentioned last week, “While risk levels have risen, there still seems to be some upside for stocks. We would recommend keeping equity levels where they are, while removing stocks that may no longer be bargains.”

David W. James, CFA

Bond Market Analysis

Conclusions: Bonds enjoyed a fine week, for a change, 10 year yields declining 11 basis points while the 30 year bond yields fell 9 basis points. The big move occurred early in the week, when initial results of the Italian election cast doubt on the election of an official who would continue an austerity program. Investors poured out of the Euro, sold stocks, and moved into U.S. treasury bonds, with the dollar index rising 1.02% and the Euro declining sharply. Except for precious metals and a few grains, commodity prices fell. Industrial metals were hard hit.

We had earlier commented to the effect that quantitative easing by the FED appears to have encouraged stock prices, but had the opposite impact on bonds. So far, that pattern seems to have persisted.

The media is obsessed with the “sequestration” which began Friday, a reduction in planned Federal spending of about $85 billion over 7 months. Except for defense personnel, we doubt significant long term economic impact, unless the Administration chooses to create hardships to induce Republicans to raise taxes: a) Even an $85 billion reduction will find the government spending will nevertheless increase ($3.55 T in 2013 v $3.54 T in 2012) after the cut. b) Over 10 years, a projected $38 trillion budget would reduce to only $36.8 trillion. c) Few of those who decry the reduction in federal spending have looked at the data. We have. Research by Trent and David has determined that reductions in government spending since the second World War have tended to increase GDP. Most of these reduction instances resulted in GDP growth, and by an average of 5.0% over the next year.

The facts are, the 2012 budget shows federal spending at $4.023 Trillion, borrowing $1.645 Trillion. The government is borrowing 40 cents out of every dollar it spends. Federal policy needs to be adjusted. Review, if you will, a four year time period in our nation. How many can you find where we made so little economic growth? From 2008 to 2012 tax receipts have actually declined. Yet government spending rose by 27%.

Our bond indicators remain strong, favorable for bond holders. Bond and income mutual funds took in net $32.8 billion in January. The economy promises growth yet not at a rate to promote much borrowing for expansion. The FED promises to continue buying bonds at a rate of about $85 billion a month. When it comes time to get rid of bonds, Chairman Bernanke says he may avoid selling them, just let them mature. And quality bonds continue to represent a good haven for uncertainty. We would maintain a good position in high quality bonds with extended durations.

F James, Ph.D.