Market Commentary by: James Investment Research (1/26 - 1/30)

Stock Market Analysis

Even with strength during some of the days last week, stocks managed to move lower, with more stocks declining than advancing. Additionally, volume was heavier on the downside days.

Investors seemed especially upset with developments overseas. The Danes and the Swiss appear to be abandoning a collaborative approach with their Euro trading partners. This has created some alarm at the extent of their currency elevation and has caused export prospects in those countries to suffer. This is something the U.S. has come to understand as our dollar currency continues to rise. The dollar is now ahead a hefty 17% over the past year and over 5% year-to-date.

This of course, impacts our exporting firms. Especially our large firms, which tend to sell abroad, get hit with linking their products with higher prices making them less attractive. Thus we learn Procter and Gamble shares are lower after guiding expected future revenue lower. Lower revenues often leads to lower profits for shareholders, so it is no wonder share prices fall back.

Some of the most frequent questions we receive at this point in the economic cycle are as follows:

After all the government stimulus, do you have a concern about inflation?

Of course, we do. We have however carefully researched periods of high inflation and found it is offset with appreciation of small stocks. Precious metals are also thought to be helpful. Right now the slow economy has given us very slow price growth, inflation is near 0%. Portfolio growth may be the best offset for future inflation.

How will you offset the problem of dollar appreciation, causing export sales to slow?

There is no perfect offset, however smaller stocks tend to sell more products at home, not abroad, and they are beginning to revive from their typical mid-term depressed year. Certainly we want to hold some large equities to diversify but not focus on them right now.

What will you do to offset the crash in oil prices?

We regret any setback in the fortunes of friends who have risked their capital to bring oil to the nation, friends we greatly admire. On the other hand, cheaper energy is a boon to any manufacturing nation and to consumers. It is estimated that declines in gasoline alone amount to more than $2,000 in expense reduction per driver in the United States. So far, drivers may be adding to their savings, but they will eventually spend. Foreigners shift manufacturing to the U.S. to gain access to our inexpensive natural gas, spending lots of money and bringing many jobs.

Lots of problems, but research suggests offsets. Perhaps that explains the strength in our long term risk indicators. For the intermediate term, our leading indicators are neutral but trending a bit more positively. Seasonality and the election year cycle favor stocks. Elevated valuation levels and excessive enthusiasm leave the market vulnerable to corrections along the way. Our forecast is for continued volatility. We suggest a modest, neutral allocation to equities, with emphasis on neglected smaller domestic securities with growing earnings.

We find ourselves in a transition period for stocks which will lead to greater volatility. As noted above our leading intermediate term indicators remain in neutral territory and we would maintain moderate equity levels.

F James, Ph.D.

Bond Market Analysis

Quality bonds have continued their trek to lower yields and higher total returns. Although 2015 is still in its infancy returns on long-term Treasury bonds have advanced an impressive 8.6%. This is especially favorable when one considers the major U.S. stock indexes are down 2% or more. Once again we see the benefits of diversification into bonds during volatile times.

What of the future? One important factor is the economy. Why? It is the fact that bonds, much like a Ginger Rogers dance routine, often features moves in the opposite direction. This week there were a few positive signs for the economy which would suggest caution for bond holders.

One economic positive is found in surveys showing growing confidence of the U.S. consumer. The government’s Conference Board released their data on consumer confidence. They show confidence is now at its highest level since the summer of 2007. As consumer spending makes up roughly two-thirds of our economy this is a factor that should not be ignored. Consumer confidence may be being helped by lower gasoline prices at the pump. Data from AAA suggests the national average price for gasoline is down over 35% over the last 12 months.

Unfortunately, there are some canaries in the economic “coal mine” that are looking distressed. Fourth quarter GDP numbers, the officials tally on the state of the economy, declined dramatically from the third quarter and were well below estimates. Some economists were encouraged by the gains in personal spending which advanced 4.3% for the quarter. However ,in an analysis performed by Zero Hedge they note the number one driver for the increase was due to healthcare (Affordable Healthcare Act). If consumers get additional income from reduction in gasoline costs, many business firms signal that, so far, there is little impact on their firm’s revenue. Perhaps the funds are saved, perhaps spending will pick up in the future.

But there are other factors favoring bonds thanks to international investors. It may seem odd to think of the U.S. as having high long-term interest rates yet this is a case where truth IS stranger than fiction. Among developed nations the United Kingdom, Italy, Spain and Canada enjoy lower relative interest rates than the United States. Further, France, Germany, Sweden and Japan sport yields at least one percent lower than our own.

Some areas almost find themselves to be in the land of the absurd. Switzerland, for example, sports negative long term interest rates. The effects are so bizarre that one Danish bank offers certain customers a negative interest rate on their home mortgages! Seen in this light, our yields of 1.68% on our 10-Year Treasury can look quite enticing.

There is another factor: So long as the dollar is strong, net exports (the difference between exports and imports) is likely to remain wide. According to the Wall Street Journal, the large net export figure last quarter subtracted l% from reportable GDP.

Presently our leading bond indicators remain in the favorable camp. This suggests the recent move in bonds is probably not over. We recommend a more aggressive stance in quality bonds where appropriate. The “moderate extension of maturities of the highest quality bonds.” which we favored in mid-January appears has so far been helpful.

David W. James, CFA F James, Ph.D.

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