Stock Market Analysis
Last week the Dow managed a weak 0.35% gain, while its return year-to-date was only 1.60%. To investors, it has been encouraging that small stocks may have begun to make their traditional pre-election year rally. After a long period in the doldrums, the Russell 2000 index began to outperform, rising 0.36% for the week and an improving 5.58% year-to-date. Small stocks frequently lead general market advances. Among the sectors, Energy and Technology issues have been doing poorly while Financial and Staples are the best.
The economy has begun to look better of late. The Wall Street Journal, for example, points out that employee compensation is growing by 4.9%. Additionally, consumers have finally begun spending some of the savings they encounter at the gas pump. Retail sales, which have been weak over the last year, grew by 1.2% month-over-month in May. Recently, job openings reached an all-time high.
After a sluggish first half of 2015 for investors, it is a pleasure to report that the intermediate term now looks brighter as more of our leading indicators turn favorable. True, our short term indicators are mostly negative and we may well experience challenges over the near term. Long time contrarians will now find enough pessimism to be of good cheer for equity prospects ahead.
An example of pessimism may be found in closed end mutual funds, which now sell for nearly a 10% discount to their asset value. Historically, this is very much in the “Buy” region.
Members of a group with whom I share coffee each week are typically bullish. This week, conversely, they forecast undecided markets, “more ups and downs ahead” and some complain of losses in their investments.
The cover of this week’s Barron’s surveys a panel of largest money managers finds them sharing my coffee group’s forecast. The panel expects indifferent performance for the rest of the year and “5% at most.”
We further find pessimism in the AAII (American Association of Individual Investors) which reports only 20% Bulls and 33% Bears, while the 47% majority are “Neutral.” AAII data shows the 20% optimism reading to be the lowest since the correction in mid-2013. (Note that was a good buying opportunity.) The majority 47% show excessive indecisiveness, which is also bullish. Trader sentiment fell from 64% to 60%; an unusual move in a week when the economic news was so encouraging. Our Risk Exposure Ratio is only 53, more of an average reading and certainly not extended.
We believe the improved outlook we note here should, after a time, be reflected in rising stock prices. We would continue favoring bargain stocks offering good relative value, profitability and strength.
Frank James, Ph.D.
Bond Market Analysis
It has been a rough year thus far for the bond market, especially for long-term bonds. Long-term U.S. Treasury bonds are down nearly 5% year-to-date, but Treasuries are not alone as corporates bonds have not managed much better. Long-term AA Corporate bonds are off 4.7% year-to-date while the iBoxx Investment Grade Index (corporate bonds) is down 1.3%.
Fortunately, the longer dated end of the curve was able to post a gain on the week as Treasuries and corporates in those maturities advanced 0.4% and 0.3%, respectively. Overall, the yield on the 30-Year U.S. Treasury bond settled at 3.1%, while the 10-Year Treasury note finished the week at 2.39%.
While Europe tries to figure out how to bailout Greece, or even if they plan to, the focus here in the U.S. has been more on the FED and when investors expect them to begin raising rates. Investors continue to look to the FED minutes as well as economic data to help gauge the likelihood of a rate increase. This is likely one of the contributing factors to the recent rise in rates and volatility over the past months.
Lately, economic data being released has not been very promising. Take Industrial Production for example. Industrial Production is highly correlated to GDP and has had headwinds since the beginning of the year and in fact has been negative five consecutive months. ISM Manufacturing PMI is another weak manufacturing indicator that has fallen significantly in 2015.
Manufacturing is not the only weak area, retail sales is another that has seen haggard growth. Data shows year-over-year sales advancing below 3% for the 4th straight month; the last five years has averaged closer to 4.8%. There is some hope however, as the U.S. jobs market has shown some promise lately. The Non-Farm Payrolls has improved over the past couple of months and the percentage of job openings is back to levels seen in 2001.
With the present economic conditions we wanted to analyze how it may impact the FED’s decision on raising or lowering rates in the coming months. We looked at quarterly GDP data and analyzed periods where the economy had contracted and then analyzed the FED Fund Rate to see if in the coming 12 months there was a rate increase or if they had fallen. We wanted to see if the past would give us some insights to what the FED may do regarding rate hikes in the coming 12 months.
The results we found going back to 1954 were very interesting. When U.S. GDP contracted for the quarter the percentage of the time the FED Funds Rate would increase was only about 27%. In fact, the average change in the following 12 months was actually a decline in rates of about 1.3%. The results show that if history is a guide, the FED will often wait to raise rates until the economy shows definitive better growth. The FED certainly does not want to be blamed for a slowdown or even recession due to them raising rates in a sluggish economy. This may be especially true during this portion of the election cycle.
Our intermediate term bond indicators remain favorable, while our short term bond indicators suggest caution. Inflation is not likely a problem at this time for bond holders but will be down the road. We would continue to hold a modest position in high quality bonds.
Trent Dysert
