What happened in the stock/bond markets last week (8/17-8/21)?

Stock Market Analysis

Last week the Dow was down a surprising 5.8% with its worst weekly loss this year. The S&P 500 stock index lost a similar amount but small cap stocks lost a little less. Selling grew as the week went on and Friday’s 531 point loss on heavy volume was a headline shocker.

We find reasons to doubt this is the beginning of a major bear market. Selling action toward the close of the week was intense and was covered anxiously by the media. Many interviews focused on how to survive a severe decline which was seemingly unavoidable. In our 42 years of experience, such conviction is more often seen near market bottoms than at the beginning of long term bear markets, where optimism in the face of problems is more common.

The AAII association collects opinions from small investors as either: bullish, bearish, or neutral. For the second week in a row, there are fewer bulls than either bears or neutral. Noted market observers such as Greenspan, Siegel and Shiller are finding “bubbles” and calls for corrections. El-Erian credits poor policies and says “Prices need to fall a lot more before wary investors get off the sidelines...”

As for stocks, Bloomberg reports enormous bearish sentiment among hedge funds. “Hedge funds spent the past month putting on trades that would profit from a decline in equities...‘short’ positions exceed bullish ones by 2.2 percentage points, their most pessimistic stance since January 2009

Barron’s confirms another contrarian observation, “A Morningstar study suggests that high outflows (from mutual funds) could actually be a predictor of positive returns...” Their observation: “In the first seven months of the year, investors have yanked almost $80 billion from domestic stock funds...” Our view: Might this not forecast domestic equities as a desirable investment area? One other positive, Reuters reports insider selling has been relatively light but buying has been relatively heavy.

A complaint from our Federal Reserve Board is that the present inflation rate of 0.1% in July is “too low.” This is strange indeed, for those of us who lived through the double digit inflation of the late 1970’s and it almost seems to be divorced from reality. For those working, inflation represents another tax, a cheapening of the fruit of their labor. It also works against the poor and thrifty.

The dark shadow for the future is world debt and what it implies. China has engaged in a massive, but well-meaning, stimulus campaign. International experts caution: “No emerging nation in recorded history has ever tacked on debt at such a furious pace as China has since 2008. A rapid increase in debt is the single most reliable predictor of economic slowdowns and financial crisis. China’s debt as a share of its economy is said to have increased by 80 percentage points between 2008 and 2013 and currently stands at around 300%.” In the past, this has been a precursor to economic distress and contractions.

An offset for America, a big manufacturer and heavy oil consumer, is found in lower energy prices. Long term, this is a blessing for the country, but not for our friends in the energy production area. Also, our strong dollar is a reflection of our economy and tends to keep interest rates low. These are major positives for our country.

Great concern and speculation have centered on potential FED actions in the months ahead. But would the economy really suffer if retirees earned 0.25% on savings rather than the 0.02% they get today? Would it really change GO/NO GO decisions by corporation officers who look to earn 15 to 20% on investment projects?

In summary, stocks were down 5.8% for the week, falling about 3% on Friday. As noted, we find too much pessimism to forecast a major bear market beginning right now; perhaps somewhat later. From the May top, the S&P 500 is down about 7.6%, which was about the average setback in 2014. It has been 10 months since the last such downturn, which was about 10%, in October 2014. Two to three such corrections per year are not unusual. Great bull markets are punctuated by a series of similar corrections, so this is not abnormal. After such a recent decline we should expect more volatility but may get a short term rebound. This would be natural but of little predictive power for the intermediate term. Our risk indicators remain positive and we would maintain our position in undervalued domestic equity positions.

F James, Ph.D.

Bond Market Analysis

It was a profitable week for higher quality bonds as the stock market tanked. Overall, long-term Treasuries advanced 1.7% on a total return basis. Indeed, most bonds enjoyed gains with the exception of high yield or “junk” bonds which often trade more like equities.

Bonds are often considered a boring investment. Perhaps this is true, but “boring” is often preferable to other investments when market dislocations occur. The 10-Year Treasury bond is known for its negative correlation to the stock market. This means it can provide excellent diversification to an all-equity approach.

Additionally, there is a certain degree of trust in Treasuries. This trust often manifests itself in times of crises. In events ranging from Nixon taking our country off the Gold Standard to the Lehman Brother Bankruptcy investors find solace in quality bonds. In the twelve months following a crises event, longer term Treasury bonds have enjoyed an impressive 11% total return.

There are other reasons for investors to consider bonds. Inflation, the bane of fixed income investments, remains subdued. Wholesale prices (PPI) are declining over the last 12 months while retail prices (CPI) are only tracking at a meager 0.2%. The decline in commodity prices helps explain some of this. The CRB Index suggests a broad base of commodities have declined over 33% in the last year. Those reliant on energy are clearly knowledgeable of the remarkable decline in oil as well.

What of the Federal Reserve? The recent devaluation of the Chinese Yuan has cascaded into weakness in other currencies; especially emerging market countries. Year-to-date the JP Morgan Emerging Market Currency Index has fallen by 12%. A move to tighten rates by the Fed may very well strengthen the U.S. Dollar further. This may be a move the Fed would rather avoid.

Also hampering the Fed may be the weakness in the labor market. The central bank likes to tout how they are data driven in making their decisions. In order to analyze the health of the labor market the Fed looks not at just one indicator such as payroll growth or the unemployment rate but a wider spectrum. They have developed their own Labor Market Conditions Index which tracks a total of 19 monthly factors. As we noted in last week’s bond commentary the levels today are so poor they are more indicative of times when the central bank looked to lower, not raise, interest rates.

Of course the Federal Reserve can and will do as their voting members please. However, a data driven analysis suggests inflation and labor factors should stay their hands.

Not all is perfect for bonds. There are growing signs of an improving U.S. Economy. Such times are not usually beneficial for bond investors. We find, for example, noticeable improvements in Industrial Production and housing. Housing starts have now topped 1.2 million on an annualized basis and have reached their highest levels since 2007.

Given the worldwide financial unrest there is a strong case for investors to have a portion of their overall portfolio in high quality bonds. We note our leading bond indicators are now neutral, not favorable or unfavorable. In this environment we suggest maintaining a position in high quality bonds with moderate durations.

David W. James, CFA

 

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