Stock Market Analysis
Sleigh bells were ringing as the market hit new highs last week. We did not make it above the 20,000 mark but a seventh week of advance is still impressive. The Dow rose 0.46 percent while the small cap Russell 2000 rose 0.55 percent. We saw about 3 stocks advance for every 2 that fell and more than 4 stocks hitting new highs for every new low. Financial and Industrial stocks did particularly well while Energy stocks eased a bit after their recent run.
Where are stocks going after the current rally? Let us look at history and then look at current risk levels. Going back to 1952 we examined the S&P 500 results when we saw a change in the elected President party. The market usually makes solid gains over the next 60 trading days or so. After the advance the market corrected and then stayed in a trading range over the next 60 days. So, if the market followed form, we would see higher markets through January. From a seasonal standpoint, January also tends to be a month of strength and in 2017 investors will be looking to redeploy large cash positions.
In gauging risk, we like to look at sentiment, monetary policy, the economy and valuations. Currently our sentiment readings are split evenly between positive and negative, but institutional readings are still overly cautious, a good sign. Monetary policy has moved to tightening and the Fed has suggested three more hikes in 2017. Our research, going back to 1970, shows results are a bit lower when the Fed changes from cutting to raising rates. However, stocks do not typically fall during these periods. We only find moderate risk here, unless the Fed starts selling off assets.
The economy has lagged for years, but we see some positive signs for stocks and only moderate risk. We follow the five regional Fed reports on activity and the average is running above 2.5 percent. Going back to 2000, stocks do twice as well in the next six months when the ratio is above 2.5 as it does when below. The market is also taking cues from possible tax cuts. After tax corporate earnings would more than double if rates actually dropped from 35% to 15%. This would be a powerful incentive for companies to grow.
Lastly, while not a good timing mechanism, valuation levels are extended. We looked at Cyclically-Adjusted Price Earnings, Replacement Costs (Tobin’s Q) and Market to GDP levels. In all cases, they are above normal and in the range we would classify as expensive. Historically, these indicated returns of 1-3 percent annually over the next five years. These levels also suggest the market could be vulnerable to shocks, whether they are political, military or economic. As such, we expect 2017 to be more volatile than 2016.
Our intermediate term risk indicators are mostly neutral and the market has excellent momentum. This usually point to rising prices but the advance may pause because of the strong advance. All in all, this is not a time to be underinvested and we still find opportunities in smaller, bargain securities.
I said this last week on CNBC click here to watch.
Barry R. James, CFA,CIC
Bond Market Analysis
Bonds celebrated their own holiday last week, one we will call Respite. After the election bonds have experienced a run of higher rates, but it paused last week. Longer term Treasury prices rose 1.1 percent and moved back into positive territory for the year. Shorter term bonds, corporate bonds and even mortgage backed bonds advanced. It was good to see bonds advance, even while stocks were doing the same.
Inflation fears have been driving bonds since August. Wage growth, as measured by the Atlanta Fed, is now rising at a 3.9% annualized rate. While the CPI and GDP price index are both running below 1.8%, inflation expectations reflected in Treasury Inflation Protected Securities (TIPS) is running right at 2%. Inflation fears may have gotten ahead of actual inflation and under these circumstances TIPS have historically offered an advantage over Treasury bonds in the next 12 months.
Bonds have also started to anticipate faster economic growth. The President-Elect has indicated significant spending increases and tax cuts. If this means more debt, then the increase in supply would tend to push bond prices lower and yields higher. Bonds could also be affected by a decrease in demand. Traders have had less appetite for new debt lately and international holdings of U.S. Treasury bonds have also been slipping. This is another reason why bond prices have been sliding.
As we look to 2017, we expect a good deal of volatility in bonds but the trend does appear to be toward higher yields. As such, we believe lower durations and shifts into a different structure are appropriate. We would slowly shift to more of a laddered approach to maturities, which allows us to take maturing bonds and reinvest them at higher yields. Also, prices on shorter term bonds are not as affected by changes in interest rates. Lastly, floating rate bonds and even inflation protected bonds make more sense. We believe there will be opportunities to make money in bonds, but the windows will be narrow and the risks higher than in past years.
Our intermediate term bond indicators are negative and we would use rallies in bonds to execute the changes mentioned above.
Barry R. James, CFA, CIC
