9/28 - 10/02 Market Commentary by James Investment Research

Stock Market Analysis

The Dow rose almost 1% last week while smaller stocks fell. Only 26 NYSE stocks touched new highs against 795 new lows and we saw 1444 stocks advance while 1805 declined. Rapid action was pretty much confined to Friday, when the market initially started down on the bad employment figures, but then reversed course and advanced sharply. A bullish sign indeed, except that volume was light. Small investors have joined professional traders in bearish sentiments. Discounts from asset values among closed end funds grew to 12% at one point, strong evidence of discouraged investors.

Both the Russell 2000 small cap index and the S&P 600 small cap index fell nearly 1% while large cap indices rose. What is going on? We are likely seeing the normal affection of investors toward large stocks which they perceive as steadier, and more trustworthy, in the face of global slowdowns and China concerns.

This action is entirely understandable coming off such a difficult quarter, where the median security on our 8,000 stock database lost 10.89%. Almost two thirds of the large securities outperformed the average, while only 43% of the smaller issues excelled. In spite of this, we believe the future will belong to smaller, value issues, the ones which have lagged for nearly a year now.

Why? 1) Larger stocks are having more difficulties with their international sales. RBC Capital reports 45% of the large cap, S&P 500 revenues come from overseas, and these will be hardest hit by the rise in the trade weighted dollar. Since June of 2014, the currency measure has risen about 19%, making our goods more expensive to foreign buyers. Large companies, such as Caterpillar, are reflecting this factor in lagging foreign sales and weaker earnings. It is the rare small firm which has extensive foreign sales. Using estimates provided by an international monetary fund, the impact of a 20% rise in currency for an export power such as the U.S. could be as much as $510 billion in lost GDP, mostly hitting earnings of large institutional favorites.

2) Smaller value issues have been out of favor for nearly a year and are somewhat depressed, selling at bargain prices. A careful long term (1928-2013) analysis by Fama and French places these smaller value holdings as superior to large growth, with long term performance superiority of about 5% annually. We believe good “catch up” opportunities lie ahead. We find periods of prolonged underperformance of smaller value often lead to strong and extended outperformance when the cycles reverse.

Our internal research shows value securities tend to resist general market declines, another point in their favor.

How to invest in today’s markets? FED tightening in the face of very poor employment reports is unlikely. With recent volatility, we believe it is wise to maintain a portion of a portfolio in fixed income. Bearish sentiment is rapidly building up and pointing the way to higher markets in the future. This is not apt to occur immediately as falling earnings, weak employment and unpredictable actions by major trading partners are hindrances which offset brisk auto and home sales. These risk factors should be offset by moderate equity positions. We would not focus on industrial, commodity and export stocks, but rather focus more on travel, hospitality and domestic service issues. Our indicators are mixed. We are generally hopeful for higher prices but would not be surprised to see another setback to clear the path. Large cap stocks are outperforming now but we look for a resurgence of small value issues in the future.

F James, Ph.D.

Bond Market Analysis

It was a strong week for high quality bonds, especially U.S. Treasuries. Investors preferred safety as market volatility picked up and economic data weakened. Long-term U.S. Treasury yields fell to 2.82%, while prices advanced 2.4%. The 10-year U.S. Treasury note ended the week below the 2% level for the first time since late April. High Yield bonds were the area to avoid, as they fell 1.8%.

The labor markets received upsetting news on Friday as the nonfarm payrolls and private payrolls both missed expectations by a large margin. The nonfarm payrolls missed expectations by nearly 60,000 jobs while private payrolls came in about 80,000 jobs under expectations. The disturbing development was the rather large downward revisions to the previous months. What does this mean for the FED and a future rate hike? Well, the FED futures have already adjusted, no longer predicting an October move, but rather a hike in March of 2016. This is an obvious sign the slack in labor might be more than the FED had expected and is likely to deter the FED from raising rates anytime soon.

We also continue to see weakness across numerous regions as reported by the FED. Our Four Horsemen of Economic Malaise (New York, Philadelphia, Chicago and Richmond) are pointing to some troubling times ahead for the economy. The most recent readings for all four are negative which has historically indicated weak industrial production over the next six months. Not so good for stocks, but a good reason to favor quality bonds.

Optimists may continue to hold hope as the ISM Manufacturing New Orders Index still points to a growing economy as the most recent reading is still above 50. Readings over 50 indicate an expanding economy while readings below point to contracting growth. The trend however, is heading in the wrong direction and points to a slower growth. It could be a matter of time before the index breaks the ever so important 50 mark and weak FED Orders reports do not indicate a reversing trend anytime soon.

On a positive note, consumer confidence has bounced back nicely over the past two months, in spite of the global economic and stock market headwinds. The Conference Board Consumer Confidence Index is at some of the highest levels since the end of the recession. Hopefully this strong sentiment can continue into the holiday shopping season; given that consumers are such a large part of the economy.

Our indicators remain neutral and we would maintain moderate durations. Bond investors often prefer bad news as bond prices often head higher. The weak labor market data and sluggish growth this past week are just a couple of reasons bonds can be helpful during trying times. Quality bonds are better defensive instruments.

Trent Dysert, Portfolio Manager

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