Aug 6, 2013 - Stock & Bond Market Update

Stock Market Analysis

It was another week of advancing markets with the large cap S&P 500 and small cap Russell 2000 posting gains of just over 1%. Of course this is really the headline story, the details are a bit less inspiring as more stocks declined than advanced on the week. Additionally volume remains weak, especially on the up days for the market.

With July behind us, we can examine the factors that have influenced the markets the most over the last three months. Every month we review the results of over 8,000 different securities. Unfortunately, this time it is a disquieting picture.

Value investing, where one favors stocks whose price is relatively cheap compared to their earnings or book (accountant’s) value, historically works quite well. However the last three months have been a conundrum for value seekers. Certain factors like Price-to-Earnings did in fact work, but Price-to-Book and Price-to-Cash worked in reverse and favored the most expensive securities.

Followers of profitability found it a difficult market as well. Companies with the worst earning’s growth outperformed their more profitable brethren. Looking at Return On Assets (ROA) also led to disappointing results.

Situations like this are often signs of a speculative market; where quality is disregarded. Even more troubling is the degree which Wall Street “wisdom” is being heralded. It is not that Wall Street advice never works, but the times it does are usually associated with a topping market. Considering that today Wall Street has over 10 buy recommendations for each 1 sell recommendation and it is easy to see reasons for concern.

Earning season continues. Already we have had well over 70% of companies offer their quarterly report. Again we are seeing a divergence between headlines and reality. According to Bloomberg News earnings (for those companies that have reported) are up 2.9%. However our analysis suggests these gains are almost exclusively the property of financial stocks. In fact, backing out the financial sector from the equation we note the S&P 500’s earnings would be down approximately 3.1%. Indeed, seven of the ten major sectors are experiencing falling earnings.

Likewise the latest economic news remains poor as well. GDP numbers released last week show for the third consecutive quarter growth less than 2%. My brother Barry James, President of James Investment Research, has many times astutely suggested that an economy growing less than 2% will feel like a recession to its citizens. Just so.

Additional troubles are brewing on the employment front. A disappointing 162,000 jobs were created last month, well below economists’ expectations. Miraculously the dearth of jobs created still allowed the “official” unemployment rate to fall from 7.6 to 7.4%. To paraphrase Mark Twain, “There are lies, darned lies, and then there are [employment] statistics.” A truer picture comes from noting the percentage of Americans with a job was unchanged last month and still remains well below the level seen when the Great Recession ended in June 2009. Incredibly, the jobs that have been created so far this year have favored part-time status to full-time employment by over a 5-to-1 margin.

Our leading indicators have yet to give us an “all clear” signal from their previous high risk assessment. Market tops usually take an extended period to complete but the data, especially the favoring of speculative investing, suggests following a cautious path today.

David W. James, CFA

Bond Market Analysis

Bonds closed the week in a strong style, for a change. What happened to change trader’s minds? The widely anticipated monthly employment report for July disappointed investors, who had looked for a strong recovery in employment, especially private payrolls, in hours worked, and earnings. They had also expected strength in personal income and in personal spending.

Only the personal spending figures brought comfort. Instead, personal income growth declined from 0.5% to 0.3%, and nonfarm payrolls fell by 33,000. Private payrolls were a real disappointment as additions fell sharply, from 202,000 to only 161,000. Average hours worked actually declined slightly, and earnings growth decreased from the prior month while hours worked pulled lower.

Worst of all, some believe, part-time employment rose by 174,000 in July. This was more than 80,000 above the employment for full time personnel. Some believe it may be laid to the Affordable Care Act provisions.

Grasping at hope, some economists tout the decline in the unemployment rate. And it did fall, from 7.6% to 7.4%. However, this most certainly was due to the 130,000 increase in discouraged workers, who dropped out of the labor force and quit hunting for a job, hardly a sign of health to the economy.

Cautioning against using lower unemployment rates as reasons to cut back printing money, St. Louis Fed member Bullard noted it was just too soon to talk of this. And indeed, it seems the reports showed more signs of weakness than strength and recovery.

We have previously written about the U.S. economy and the changes needed to generate strength, focusing on stronger export markets and encouragement from Washington, with a cessation of perceived hostility toward business.

The 1.5% increase in factory orders was judged to be very weak, especially when measured against the 3% reading of the previous time period. All this evidence of a weak economy served to rally the bond markets, which closed strong.

Many bond investors have been listening to warnings from the media and headed for the exits, withdrawing $43 billion from taxable bond mutual funds last month. This amounts to the largest-ever such outflow according to ICI. Some investors have decided to leave the perceived risky bond market and go to equities, supposedly safer. In this, they ignore metrics of the past, which found standard deviations of annual changes in bond prices to be less than 10% while stocks sported similar figures of over 20%. The facts are; bonds are safer to hold than stocks.

Sentiment figures of today’s bond investors continue to reflect extreme fear of holding bonds. The facts are; bond investment of course carries a risk of loss, but it is moderate when compared to stocks.

Afraid of a big decline in bond prices? Join the crowd. But the typical investor might ask when was a market top so widely heralded by extremes in sentiment? Did investors fear tech stocks at the peak of the internet craze, in the late 1990’s? How about the craze for Japanese investments in the late 1980’s, just before the 25 year decline? Did the typical investor fear housing markets in 2007, did they fear home prices might fall out of bed? (Homes are still down 25% in spite of a recent recovery.) Is it possible that the economy could turn lower, interest rates could decline, and bond prices would rise instead of declining? Today our risk indicators continue favorable, and our research shows owning some bonds helps investors reduce volatility with only modest reductions in return. High quality bonds permit easy changes in average maturity should this be indicated in the future. We would continue to hold high quality bonds of modest durations.

F James, Ph.D.

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