Jan 7, 2014 - Market Commentary by: James Investment Research

Stock Market Analysis

Conclusions: Stocks opened the year with a flat week on lower volume, about as many stocks advanced as declined, some averages showed a tiny decline. . Nearly four stocks set new highs for each new low. What do we make of prospects for the New Year? Profits? New problems impacting corporate profits make firms unlikely to repeat the strong profit growth seen this past year. They include:

• Thirteen tax increases imposed in 2013.
• New Obama Care expenses. The latest to be revealed is a tax on the costs of the insurance which many corporations furnish for their workers, estimated to be over time about a 25% increase in these costs, and it cannot be deducted because it is labeled a “fee”.
• Rising interest rates increase the cost of doing business while making home ownership less attractive.
• In many states, labor costs will rise due to mandated increases in minimum wages.
• Unseasonably cold weather brings new expenses and, sometime, costly delays.

It is interesting that our local paper conducted its own survey of small business firms and got these comments, many of which parallel our observations above:

• “Corporate tax rates are too high and the tax code is too complicated;
• Regulations — should be kept to a minimum, when there is a clear and critical need; be as simple as possible to administer and comply, minimize burdensome and complex reporting requirements;
• Right to work —DRMA members support the concept of the open shop which allows workers the opportunity to choose to join labor unions as opposed to being forced to join;
• The shortage of skilled workers;”

Do our political leaders benefit from experience? Mark Twain said “The cat who sat on the hot stove will never sit on a cold one.” Would that our government in Washington showed the same insight and abandoned techniques that have not produced good results, such as “deficit spending” and “stimulus” and “quantitative easing.”

Instead we find teenage unemployment rate at 23.4%. It has increased over the past month-to-month and has not improved since the bottom of the recession. When the new administration began, at the bottom of the economy, the official teenage unemployment rate for December 2008 was 20.8%.

For all workers, the unemployment rate on December 2008 is almost the same as the rate today. There has been little recovery in jobs and not much to show for 5 full years of money expansion and at least $4 trillion in deficit spending. The political class has a deep faith in stimulus spending. But there is little hard evidence it helps.

It would be fair to say, barring major external changes, the business environment is likely to remain stagnant and stocks are unlikely to get a big boost from higher profits. Normally, stock tops form in the face of excess enthusiasm. How is investor sentiment ?

Stocks aren’t cheap: Shiller’s long term price earnings ratio has averaged near 16, recently the ratio was near 23
At major market bottoms the price/book on the Dow has been less than 1.
Recently it reads 3.2
At major market bottoms the Dow dividend yield has been over 6.0%
Recently the Dow yields 3.1%
Price premiums for put call ratios have been high at bottoms, typically near 2.4 and 0.42 at tops. Recently this ratio was a low 0.67
Put/call volume has ranged from 1.20 to.60, with lots of puts traded at bottoms, few at tops. Recently a low 0.48 was recorded

These numbers reveal much enthusiasm among investors. Some of this is normal, stocks just completed an exceptionally strong year. Even so, equities are closer to a top than a bottom and at this juncture we need to carefully monitor our risk indicators.

Our leading intermediate indicators are basically neutral. However, our long term indicators remain favorable and this is seasonally an excellent time to hold smaller value (“bargain stocks”). In view of the extended nature of prices we would maintain a conservative bias while trimming portfolios which hold excessive equities.

F James, Ph.D.

Bond Market Analysis

Conclusions: After ending the year with the highest yield on the 10 year Treasury the New Year saw a decline in yields. Of course, for the entire holiday shortened week we saw very little action overall in the bond market.

The bond market has been greatly affected by the Federal Reserve’s Quantitative Easing (QE) programs. Nominally, these programs have been designed to keep longer term interest rates low. However the difference between their theory and reality has been startling.

Since the Fed began its extraordinary moves in November 2008 we find long term Treasuries (10 or more years to maturity) have LOST an annualized 4.9% when a QE program was in effect. During the same time frame when QE programs were not operational those same bonds gained 21.9% annualized. Forget about tapering, bond holders want to know when the Fed’s “help” will be over.

Clearly 2013 was an underwhelming year for high quality long-term bonds. From a historical standpoint the silver lining usually comes in the following year. Using Ibbotson data going back to 1926 we examined all the years where, on a total return basis, long term government bonds lost 5% or more. In the following year bonds typically gained over 11%.

Another positive is the current low inflation rates. Whether we measure the Personal Consumption Expenditure, the Consumer Price Index or the Producer Price Index, we find all of these inflation yardsticks are running below 1.5% on a year-over-year basis.

As we look to our indicators we note they are generally favorable suggesting 2014 has an opportunity to be a much better year than 2013. However, as we noted earlier, much of this is in the hands of the Fed’s QE program. As their program ends the markets will likely return to normal and normal economic factors will offer investors superior guidance. For now we would maintain a moderate duration.

David W. James, CFA