Market Commentary by: James Investment Research (3/23 - 3/27)

Stock Market Analysis

Last week stocks sagged with nearly 1,200 advancing against about 1,700 declining. Volume mostly declined on the pullback, but when stocks tried to rally Friday, volume fell off sharply. New highs were achieved by 367 NYSE issues, only 77 set new lows. Notwithstanding the relative number of new highs, it was, on the surface, a discouraging picture.

Margin debt declined again, and so did customer free credit, both thought of as negatives. Overall, the entire economic picture includes element of weakness as well as strength.

Weakness - Last month the coincident/lagging index declined again to 96.6 after topping off at 97 in December. This index has a fine record and it is signaling economic weakness ahead; the final quarter of last year provided a real GDP of only 2.6%, well below the 3.0% average of the years between 1945 and 2009. Further, U.S. exports declined from a real growth rate above 10% to only 2.5% which is often explained as due to the stronger dollar. Retail sales in the U.S. are reported as down 0.2%, even excluding auto and gas purchases.

Stock prices have risen so strongly, one can develop a sense of overvaluation; equities are now valued at 151% of our GDP. This ratio was exceeded only once, directly after the internet craze in March 2000 (then 174%). At the major bottom in 2009 the ratio was near 70%.

Strengths - S&P 500 companies are buying back shares at a prodigious rate, more than $550 billion annually, reducing tradable shares, thereby increasing earnings per share; More individuals are working, Initial jobless claims improved again; Inflation as measured over the past year is near zero.

It is a strength that petroleum is in excess supply. It is estimated that 450 million barrels are now held in storage in the U.S., which uses about 19 million barrels a day. Contrary to the conventional wisdom, prices are likely to go lower until a bit nearer the low cost producer. Morse estimates cost of production for Saudi Arabia to be only $4 a barrel. Again contrary to conventional wisdom, we look for lower energy costs to be a boon to citizens, reducing costs of transportation and production of goods and thereby encouraging increased consumption.

The strength of the dollar, which has risen by 21% over the past year, is both a curse and a blessing. It makes our products more expensive to foreigners while lowering interest rates at home. On the whole, however, our internal research matches academic theory which holds a positive relationship exists between strength of the dollar and rising stock prices. Overall, we judge this to be a positive.

Declining commodity prices track with lower interest rates increasing the desirability of equities versus fixed investments. The Goldman Commodity Index showed a 38% decline over the past 52 weeks. This is a positive.

Central banks have resorted to the equivalent of money-printing, which will eventually lower the value of currencies, including the dollar, but first it puts money into the hands of the affluent who have been spending with abandon, pumping up home construction and sales, buying expensive goods such as airline travel (note higher revenue for airlines) generating demand for cruise tickets (and leading to recent orders for additional cruise ships as revenues rise). An estimated $3.4 trillion in assets have been created out of thin air by the FED since 2008 and their actions are beginning to be matched by foreign central banks. This new currency is likely to wind up in the hands of the affluent; who seek positive investment returns and purchase equities.

We are most often contrarians, believing that distain for the market often creates opportunities while too much affection often comes with overvaluation. We note, therefore the Bank of America survey which finds “...the percentage of global money managers who are underweight American equities is the highest since 2008...” likely reflects good tidings for equity investors. A recent Bloomberg release headlined “Everyone Hates U.S. Stocks With Sentiment Worst Since 2001”. Surveys of smaller investors also show little desire to buy stocks (AAII Reports).

Further support for equities comes from the Presidential Election year cycle, which finds equities (and economic activity) tend to do best in the Pre-Election year (this year.) Strength in small stocks is often noteworthy and indeed we find the Nasdaq Composite in March has set a new high, up more than 280% since March 2009, while the Russell 2000 index of small stocks is ahead 262% since March 2009 and also recently at a new high.

Sectors showing noteworthy strength this month include finance and health care, whereas energy and utilities have lagged.

The mixed picture of the fundamentals provides mixed guidance. In this case, we rely on the risk indicators we developed and have used for over 42 years. Right now they project a neutral, not a negative signal for the intermediate term and a very strong array for the long term. We detect few signs of the excess enthusiasm we saw as the market was topping in 2006. At major tops, doubters are few, enthusiasm is almost universal.

That is not the situation today, causing us to assign a very low probability of a major 2008 type bear market. Of course, lesser corrections are normal in the market. We believe carefully selected undervalued equities are likely to represent profit opportunities.

In today’s environment we would continue to feature bargain stocks which enjoy good relative value, profitability and relative strength. We would continue to hold moderate levels of equities in client portfolios.

F James, Ph.D.

Bond Market Analysis

For the week the yield curve steepened slightly. This means shorter maturities saw a decline in yields (about 2 basis points for the 2-Year Treasury) while longer dated maturities experienced a rise in yields (with the 30-Year Treasury seeing a hike of 6 basis points). Differences could also be seen based on quality. While returns on the high quality Treasury market generally sagged, the High Yield (sometimes called “Junk”) arena advanced.

Of course over the last 12 months the normal parameters have been for a flattening, not steepening, yield curve. We note the 2-Year Treasury Yield is roughly a quarter percent higher than it was a year ago while the 30-Year Treasury Yield is over 1% lower than it was. Why the different path?

Often it has been remarked that shorter term debt moves at the whims and perceived whims of the Federal Reserve. Much has been made in the national media about potential rate hikes by the Fed this year. As one might expect shorter dated maturities are rising in anticipation of this.

The curious thing about bonds is that longer dated bonds are typically much more influenced by the economy rather than Fed decisions. Again, being a curious beast, bonds usually offer investors their best returns when the economy is soft.

So what is the state of the economy? Our last reading of 4th Quarter GDP showed middling to poor growth of 2.2%. The data released so far in the current quarter suggests a lower GDP number for the start of 2015. New Orders for Capital Goods (excluding air and defense) are often a good barometer for business spending. This has now been negative for six months in a row and is a disquieting trend. Nor is this data item alone in disappointing economists.

If we examine the important monthly releases from January onward we can compare the actual data versus economists’ (surveyed by Bloomberg News) projections. In roughly 70% of these cases the actual data has been below expectations. Although this does not guarantee a dismal GDP print for the quarter it will provide unwanted headwinds.

Neither do the international economies appear ready to springboard jubilantly higher despite the new Quantitative Easing (QE) type of programs being tried in Europe and elsewhere. One of the better “divinity sticks” for worldwide economic activity is the Baltic Dry Index. This index measures the global shipping costs of bulk (dry) items. Presently, the index is near some of its lowest levels in its history.

It seems the tea leaves suggest subdued economic activity both here in the United States and abroad. This should be good news for bond investors. Indeed, our leading intermediate bond indicators remain favorably positioned. We believe opportunities are still present. Investors should continue to hold high quality bonds of moderate durations in this environment.

David W. James, CFA

 

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