Market Commentary by: James Investment Research, Inc.

Stock Market Analysis

Conclusions: The government shutdown in Washington was not nearly as disastrous for the stock market as much of the financial markets predicted. For the week large stocks like those of the S&P 500 were flat. Small stocks such as the Russell 2000 even advanced 0.4%.

For those who look at history rather analysts’ modeling this is not really a surprise. During the last shutdown in 1995 and 1996 the stock market actually advanced 5%.

Why the difference between reality and expectations? Much of this is due to analysts forgetting that high levels of fear usually generate opportunities. Such was the case in the Fall of 2012. Worries over the fiscal impasse (taxes and spending) brought about higher fear levels and the start of a surprising rally.

Today we see growing signs of fear. Our James Fear Gauge compares the VIX to the value of the market as measured by the S&P 500’s trailing PE ratio. Two weeks ago we found fear was being discounted to the tune of about 20%. In the last year when fear has been that disregarded stocks have usually declined in the next week 70% of the time. Now, however, fear is actually at a premium and, again, over the last year, 70% of the time the markets rise in the following week.

Additionally the market continues to take comfort from the high growth in the supply of money. M2 is a broad gauge of our nation’s money supply. When we look at the real money supply (M2 – CPI) we find since 1981 it usually grows about 3% a year. Today’s real rate is a robust 5.3%. Such easy money continues to help push stock prices along.

One other helpful development is the inflation differential has turned positive. While inflation is usually associated with bond risk, the types of inflation can often provide insights for the stock investor. Wholesale inflation such as the PPI often acts as a proxy for the costs facing a company. Similarly, retail inflation (CPI) provides a view of how much of these costs can be pushed towards their customers. The last readings on inflation suggest companies are finding the ability to push higher prices even above the rising costs they face. Needless to say, this is historically a good sign for corporate profits and future stock returns.

Today our leading indicators remain in the favorable camp. With fear at higher levels there should be opportunities within the stock market. We would add equities for underinvested accounts.

David W. James, CFA

Bond Market Analysis

Conclusions: Despite growing uncertainty over the debt ceiling the Treasury bond market generally remained well-behaved. The 10 Year Treasury Bond saw a rise in yield of only 2 basis points on the week to close at 2.66%.

The U.S. dollar has weakened lately and since July 4th the dollar is down over 3% against our major trading partners. The dollar’s recent weakness is not mirroring the strength that the U.S. Presidents Cup team showed over the weekend.

For the hourly worker, wage growth has been on a sharp downward path since 2010. Average hourly earnings grew by less than 2.5% over the past five years. This is lower than any time going all the way back to 1970. At the same time, corporate profits are at all-time highs. This is not surprising as capital and labor share the fruits of their partnership and over time this partnership has worked well. Their relative share of profits ebb and flow but over time the overall economy increases and all parties benefit.

Healthcare is a sticking point in the latest budget and debt ceiling negotiations. We frequently hear about the inequality of incomes in the United States but what isn’t talked about frequently is what proportion of healthcare is received among the U.S. population. The Agency for Healthcare Research and Quality reported that in 2010, just 5% of the total population received nearly 50% of healthcare expenditures. The average expenditure was per person was over $87,000 and was most common among those with public only healthcare coverage. This highlights the importance of healthy habits and preventative care in reducing health care spending.

Mark Perry from AEI reports that we have more breweries in the U.S. than at any time going back to 1887. We often talk about the choice consumers have between price, quality, and speed of service. This development should be good for consumers as there are more choices, overall prices should decline due to the increase in supply, and speed of service should increase. Don’t tell Ben Bernanke as he might try to use the decline in prices to justify more Quantitative Easing.

Our bond indicators continue to remain neutral but have been moving more unfavorable lately. We are concerned about the quality of certain leveraged loans as demand is soaring in the search for higher yields. Does this remind you of a time in the past? We recommend moderate positions in high quality bonds as well as some cash for future buying opportunities.

Matt Watson, CPA