May 6, 2014 - Recent Market Commentary by James Investment Research

Stock Market Analysis

Conclusions: After much hesitation, stocks rose last week, with 2,168 stocks rising on the NYSE, against 1,047 declining. More than three hundred stocks set new highs against just under one hundred new lows. Volume rose from 3.3 million shares to 3.9 million. However, daily volume was highest on the day of declining prices.

Short term progress in the stock market appeared to be driven by two major reports last week; U.S. output and U.S. employment. The GDP reports of the total output of U.S. workers turned out to be a major disappointment. The 0.1% change was too close to zero growth. For some time Barry has remarked that growth below 2% would not be sufficient to move the country forward and to most people, “It would seem as if we were in a recession.”

On the other hand, Friday’s report by the Labor Department of 288,000 new jobs was the best in two years and a joy to the bulls. Bears discounted the report of lower unemployment rates (from 6.5% to 6.3%) as reflecting 806,000 discouraged workers leaving the labor force. According to Investors’ Business Daily (IBD), we remain 110,000 workers below the peak employment in January 2008, before the recession. But reports of new jobs are always welcome and stocks responded with a low-volume advance.

When news conflicts, one turns to other information to assess likely future equity prospects. Stocks have come a long way since March 2009 when the Dow touched 6,547.

Major market tops often find extended valuation metrics among the individual stocks in the major averages. For example, near the peak in September 2007 the stocks in the SP 500 displayed average price/earnings ratios of 26.22. Recent comparable figures of 23.8 were not so extended but still elevated. However, 2007 price/book averages of 4.36 were somewhat below recent 4.96. Further, price/cash ratios are slightly more extended now, 13.87 versus 13.75 at the previous peak. The valuation picture is mixed, but extended enough to be worrisome.

The normal sequence of tops is that small cap issues top out first, large cap stocks later. In September 2007, many small cap issues had already peaked, while 17% of the larger SP 500 issues were in downtrends. Today many small cap stocks are well below their peaks, while only 8% of large stocks are in bear trends (where the individual security is down 20% or more from its 52-week highs).

Sentiment is important in determining tops, too much enthusiasm is a negative. Today client caution is in contrast to advisers’ enthusiasm.

Earnings? At this point, more than 3 S&P firms are reducing earnings guidance for each increase.

Our leading intermediate term stock indicators are neutral today, but they do not yet signal a favorable risk/reward ratio. International tensions with Russia continue to be elevated. We favor a cautious approach for equity investors.

With the very strong long term indicator picture today, we see little likelihood of a severe recession and stock crash on the order of 2008. Lesser corrections and declines are however more likely. Supportive initiatives from Washington, including lower taxes, fewer regulations, and a friendly attitude toward business success, might kick off an extended bull market, just as it did in the mid-1980s. Long term, we believe it likely that our natural entrepreneurship and the initiative of our tech savvy citizens combined with abundant cheap energy will eventually bring American prosperity and leadership back to the world.

F James, Ph.D.

Bond Market Analysis

Conclusions: It was a good week to own longer term Treasuries. The 10-Year and 30-Year Treasuries declined 6 and 8 basis points, respectively. Of course, lower yields suggest higher bond prices.

Jobs continue play an important role in the bond market. Typically, bonds move in reverse fashion of the economy. So, most would have expected a sell-off in bonds on Friday’s employment report.

However, cynics have begun to take the headline numbers with a grain of salt. Thus, headlines suggesting jobs have increased by 288,000 and an unemployment rate of 6.3% are viewed with a grain of salt. Indeed, we find the entrepreneur class shrank to the tune of 115,000 jobs. These are the real job creators and they are needed if our country is to enjoy its best economic growth. Further, fewer than half of all adult Americans have a full-time job today. Mark Twain appears correct when he suggested [paraphrased], “There are lies, darned lies and then there are statistics.”

The GDP numbers released on Wednesday were eye opening. The economy “grew” at a horrendous 0.1% rate. Surprisingly, the numbers are actually worse than that. Factors that pushed GDP into positive territory were higher utility bills and citizens paying for the Affordable Care Act or Obamacare. With growth like this who needs recessions?

Still, there is reason to expect better economic growth in the second quarter. Weather is undoubtedly better for most of the nation. Already some of these spring economic “shoots” are becoming visible. New orders in manufacturing, for example, are on the rise. Still, the rate of overall economic growth is likely to be below many economists’ expectations. Already, GDP numbers of 3% growth in the 2nd quarter are being whispered about on Bloomberg News. Disappointment seems likely.

Given our previous forecasts of declining bond rates and rising prices, it is gratifying indeed to receive the media’s: “Last week long term bond rates touched the lowest levels in at least five years.”

Currently our bond indicators are favorable. Given the continued unrest and instability in the Ukraine it seems likely many international investors will seek the relative safety of our Treasury market. We would continue to hold high-quality bonds where appropriate.

David W. James, CFA