Stock Market Analysis
It was a difficult week for the stock market. The large capitalization S&P 500 fell 1.2% and smaller issues such as the Russell 2000 declined almost 0.8%. On average, more stocks declined than advanced. Overall, financial and technology stocks had the most difficulties with both sectors down 2.5% or more.
There were a few bright spots. Utilities, acting as a bond proxy, gained 2.6%. Further, volume for the market was heaviest on Friday when stocks advanced.
Currencies remain a hot topic. The Swiss government announced they would no longer maintain a peg of 1.20 Swiss Francs to receive 1 Euro and would instead allow the value of their currency to float. Given the relative soundness of the Swiss financial system versus a free-wheeling Eurozone it is no surprise the Franc appreciated in dramatic fashion. It now takes less than 1 Swiss Franc to receive a Euro.
Our U.S. Dollar has also continued its pattern of strength. Compared to the Euro we are seeing our strongest values since 2003. Our currency also remains strong versus many of the other major currencies. The impact of a stronger dollar will likely be to curtail our country’s export growth. Given that exports comprise approximately 13% of our country’s GDP this bears watching closely.
Some of the economic reports released this week offer curious conclusions. Retail sales are an excellent example. The headline numbers suggest December was a disaster and that sales fell 0.9%. However this headline number is seasonally adjusted; a process where economists try to take out the month-to-month seasonality effects to offer numbers that can be more easily compared. Without the seasonality effect retail sales jumped over 14%.
Some would expect December, with its holiday shopping, to be a strong month and thus in need of seasonal adjustment but have the economists adjusted the number too much? Perhaps. If done correctly the retail sales numbers should be the same over a 12 month time period because it should negate all the positive and negative seasonal adjustments. However this is not the case. Over the last 12 months the non-seasonally adjusted numbers are almost 1.5% higher than the seasonally adjusted numbers.
One number that is a concern is Industrial Production. Industrial Production is probably the best monthly gauge on the state of the economy. For the third time in the last five months the numbers have been signaling contraction which is something we have not seen since 2009.
Earnings season has finally begun in earnest. So far approximately 8% of companies have offered their quarterly reports. As is typical, earnings are moving ahead of expectations. However, this is a number that is often managed by the companies themselves with the hopes of being able to surpass them. What is interesting is the relatively poor sales numbers. In aggregate, sales are about 0.5% below prognosticators expectations according to Bloomberg News.
We continue to look for transitions in leadership in 2015. While last year favored large capitalization stocks now we see some smaller cap issues pulling forward. Likewise we should consider areas that may have been shunned in the past. This may include gold which has become despised by many pundits. In a recent survey by Kitco Gold, 70% of their surveyed economists expect gold to fall below $1,000 an ounce in 2015. Contrarians typically rejoice in the wake of such bearishness.
Overall our leading indicators remain mired in a more neutral configuration. Our longer-term indicators remain favorable suggesting a massive decline similar to 2007 and 2008 is unlikely. However that does not mean volatility is dead. As we noted in this year’s Economic Outlook we expect 2015 to be year of higher volatility with dislocations. Currently we need to continue exercising patience and maintaining moderate equity positions.
David W. James, CFA
Bond Market Analysis
While stock investors suffered declines last week, it was a different story with those invested in bonds. Three-year Treasury issues moved higher as yields declined 16 basis points, and the 10-year yield fell 15 basis points. It is interesting that the 30-year bond yield lost only 11 basis points.
More than likely, foreign investors were after protection from currency disruption of their home currencies, and 10-year maturity issues are more commonly accepted than longer issues. Bloomberg News reports currency inflows from Russia, and certain European countries such as Spain and Luxembourg.
With these trends in mind, it is not surprising the dollar (DX) has appreciated 15% against our trading partners over the past 52 weeks and more than that against the Euro and Swedish Kroner. The dollar has also appreciated a strong 14.9% against the Japanese yen.
To this trend, we find likely buyers reflecting slowing economic trends here at home as manufacturers encounter slower buying from our trading partners overseas. This is a major factor in U.S. demand, estimates hold that our exports amount to approximately 13% of U.S. GDP. It is no surprise that business inventories have risen while Industrial Production declined. The most recent reports for December find Capacity Utilization off slightly, fewer machines at work rather than more, as Manufacturing production slows. Historically, bonds prosper when the economy suffers or stalls.
While the Chinese Yuan has not been subject to such currency weakness, the Chinese economy is weakening. Is this important? U.S. trade with China alone is said to have risen from $2 billion in 1979 to $562 billion in 2013. Quoting from a Congressional Research Service (CRS) report for Congress, “China is currently the United States’ second-largest trading partner, its third-largest export market, and its biggest source of imports. China is estimated to be a $350 billion market for U.S. firms.” China is the largest foreign holder of U.S. Treasury issues (nearly $1.3 trillion recently).
Trade with China has been a success story, for both the U.S. and China, adding to the GDP in both countries. But trade does not always lead to prosperity. Many European countries with faltering economies and failing socialist governments suffer from an increasingly weaker currency, the Euro, and the European Central Bank has embraced “Quantitative Easing” as the solution to its slow growth. In the U.S. Quantitative Easing resulting in an increase of $3.5 trillion in the supply of money while GDP increased by only $1 trillion.
Manufacturing for exports has weakened and our global trading partners appear to be slowing. Inside the U.S. Industrial Production appears to be slowing after a strong 2014. At least temporarily, Quantitative Easing in the U.S. has ended, permitting market forces to more efficiently set prices. Our indicators have strengthened over the past two weeks, and we suggest investors should favor a moderate extension of maturities of the highest quality bonds.
F James, Ph.D.
