Nov 20, 2013 - The Stock and Bond Market Analyses

Stock Market Analysis

Conclusions: Did we mention the market hit new highs again this week? The Dow rose 1.3%, the S&P 500 advanced 1.6% and the small cap Russell 2000 jumped 1.4%. The rally is further confirmed when looking at the internals of the market. About twice as many stocks advanced as declined and about four times as many stocks set new highs as set new lows.

How long can this go on? After running up over 20% this year, some fear the market can’t head up more. However, market rallies don’t die of advancitis (simply rising to new highs). In fact, our research has consistently found that long term advances tend to continue to advance.

However, advances do run into trouble when everyone seems to know about the good deal. This can be indicated when valuations are out of sync with the underlying asset or when sentiment runs way too hot. Valuation measures are extended. While the S&P 500 index has an elevated Price/Earnings ratio of 19.8, the typical stock in the S&P has a PE over 34. This is of further concern because earnings and sales have been subpar. In addition, the market is valued well above the production of our economy, another sign of lofty prices.

Given the elevated valuations, how is sentiment running? Of seven key sentiment indicators we follow; 5 are showing excess enthusiasm and the other two are only neutral. None are pointing to the pessimism we prefer to see. Given these negatives, one might assume a major correction is right around the corner. However, the Federal Reserve has its foot on the monetary accelerator, and bonds have had little allure. Everyone seems to be looking for an alternative to bonds and people are itching for higher returns. As such, the market continues to follow the path of least resistance – going higher, for now.

Our stock indicators are not positive, but neither are they overly negative. It is hard to make a case yet for an outright cut in equity levels. We haven’t been running excessively high equity weightings, so we think it prudent to stay the course. We are ready to begin thinking about how we would lower levels, but we aren’t ready to pull the trigger yet. Still, we would use the recent run up in prices to sell some positions in overinvested accounts.

Barry R. James, CFA, CIC

Bond Market Analysis

Conclusions: The bond market rallied this past week, even as the stock market set new highs. The yield on the 10 Year U.S. Treasury note fell to 2.70% from 2.77% a week earlier, while the 30 Year Treasury bond closed at 3.79%. High quality bonds such as investment grade corporate bonds and long-term U.S. Treasury bonds gained the most as they returned 1.0% and 0.7% on the week. Junk bonds advanced; however, they lagged the higher quality issues as they only advanced 0.1%.

The U.S. Treasury bond market was helped in large part by FED Chairman nominee Janet Yellen and her statements before the Senate Banking Committee. She described the U.S. economy as subpar and not performing up to its potential. In addition, she communicated the FED will likely continue their low rate policies, ie: quantitative easing. If her recent confirmation hearing is not enough, one could look to her past research for guidance to her future actions as FED chair. A number of her past studies have focused on maximizing employment. With the unemployment rate hovering over 7%; it is unlikely she would begin to pullback bond purchases when she takes the reins in 2014.

There were several economic releases this past week pertaining to manufacturing and production in the U.S. Two reports in particular were the regional FED reports from Chicago and New York. The first report, the Chicago Fed National Activity index was positive for the second month in a row and the highest reading since February of this year. The second regional report released was the Empire State Manufacturing Survey. Here a slightly different picture emerged as the index turned negative for the first time in five months. These are two important reports we follow closely as they are two of the four components in our “Four Horseman of the Apocalypse” indicator, which projects future growth in industrial production. Even with the Empire Manufacturing survey turning negative, we still see three of the four components are positive, suggesting growth over the next several months.

Lately, we have seen an increase in the number of economic reports not meeting expectations. This might be an indication that economists may have been too optimistic during the late summer months. During those months, the Citigroup Economic Surprise Index was running over 50; an indication economists were underestimating the strength of the economy. However, that trend has shifted as expectations are converging with reality and the index is trending lower. Our research typically finds this is a good trend and often points to advancing prices for bonds in the coming months.

Inflation still remains low and has not shown any signs of picking up. The CRB Commodity index is down 7% year-to-date as a number of commodity prices such as: gold, wheat, and corn are down over 25% this year. Our short term bond indicators are stronger and our intermediate bond indicators are beginning to improve. There may be opportunities in the coming months, especially if the stock market corrects. Until then, we recommend keeping bond portfolios in a position of lower volatility with modest durations in a combination of high quality bonds and cash.

Trent Dysert