Mar 25, 2014 - Recent Market Commentary by James Investment Research

Stock Market Analysis

Conclusions: The stock market on Wednesday did not take kindly to Janet Yellen’s speech as the markets fell late in the day. However, the markets were still able to press on and end the week on a high note as the SP 500 index gained 1.38%. Smaller issues of the Russell 2000 index also ended the week higher; up 1.07%. Most commodities fell as the CRB Commodity Index declined 1.1%. Volume was on the lighter side for the first four days averaging about 621 million shares. Year-to-date the volume has averaged over 700 million shares. The heavy trading on Friday was largely the result of “quadruple witching” or the expiration of option and future contracts.

On the housing front, the data remains mixed. Housing starts are down 6.4%, while existing home sales have declined 7.1% over the past 12 months. Building permits on the other hand are up 6.9% over the past year. Building permits are considered a leading indicator for future growth in housing; however, the recent rise over the year can be misleading. Why? The majority of building permits have been in multifamily housing units, otherwise known as apartments, which have increased 26.8%. Single-family units during the same time are actually down 2%. One cause for this could very well be the sudden rise in mortgage rates last May and June. This had a dramatic impact on potential buyers as they saw their buying power fall and mortgage payments increase.

Housing has its headwinds, but the markets got a boost as manufacturing appeared to bounce back from the harsh winter months. Industrial production rose 0.6% in February after two months of declines while the Conference Board’s U.S. Leading index also gained ground. The Philadelphia Fed Business Outlook and the Empire Manufacturing index also pointed to signs of an expanding economy. All of these are good signs for an economy that has appeared sluggish so far this year.

The economy might be finding its footing, but we are beginning to see warning signs that investors might be too optimistic when it comes to stocks. For example; we have found that Wall Street wisdom is not necessarily the best advice to follow. Our research shows following Wall Street’s advice and buying those stocks with the highest estimated growth, hasn’t worked well. In fact you would have actually lost money dating back to 2000. Often it is best to look for those stocks that are neglected and have the lowest estimated growth, as they typically offer better returns over time. Unfortunately, over the past four quarters, we have seen a disturbing shift as stocks with the highest estimated growth have outperformed those stocks with the lowest estimated growth. In the past this has been an indication of a speculative market, a market that is overvalued.

A couple other indicators are worthy of attention. The percentage of stocks in the SP 500 index that are above their 50 day moving average and mutual fund flows for equity funds. Currently 76% of the SP 500 stocks are trading above their 50 day average. Historically, levels above 70% indicate stocks are overbought. On the mutual fund front, equity purchases have risen dramatically. According to the ICI (Investment Company Institute) in February we saw the estimated net inflows into domestic equities were the largest in over a year. From a contrarian point of view this is a possible sign investors are buying at the top.

Our intermediate indicators are unfavorable and point to higher risk for stocks. Investors would be wise to be cautious in these markets and we would suggest trimming stocks in overinvested accounts.

Trent Dysert

Bond Market Analysis

Conclusions: The Fed met, Janet Yellen spoke and the bond market turned weak. While not the only news affecting the bond market last week, the Fed meeting dominated headlines. The Fed made changes to its verbiage and more importantly, its benchmarks. Thru it all, the bond market lost ground in all sectors except intermediate term treasury and high yield bonds. Nonetheless, longer term, high quality bonds continue to lead so far this year.

Having read the comparison with last month’s Fed statement, the big change deals with benchmarks for shifting to a less accommodative policy. While it had been 6.5% unemployment and 2% or less inflation, the Fed took away the 6.5% while leaving the 2% or less inflation. They said they would use other factors to determine full employment. Most likely these will deal with underemployment and the labor participation rate. Maybe more gripping for the bond market was the talk of raising the Fed Funds rate only six months after quantitative easing has come to an end. This is earlier than people had been expecting. In addition, a survey of Fed governors shows they expect the Fed Funds rate to 1% by the end of 2015 and 2.25% by the end of 2016. Nothing has really changed, but investors were spooked nonetheless.

Economic news was also a little unsettling to bonds. Industrial production rose stronger than expected and Capacity Utilization also improved. Manufacturing grew nicely and the two Fed reports from New York and Philadelphia also rose. Lastly, the Leading Economic Indicators jumped nicely. The only economic downside was in the housing market, which slowed down considerably.

Uncertainty usually creates opportunity. Future Fed action isn’t really much of a concern in the short run and the sell-off in bonds creates a buying opportunity. Our bond indicators remain firmly positive and we would use the pull back to add bonds to underinvested accounts.

Barry R. James, CFA, CIC