Stock Market Analysis
It is often said that investors “Buy the rumor and sell the fact”. This suggests investors often like to buy stocks in anticipation of good news and then sell once the good news becomes fact. But, what happens when Wall Street “buys the rumor” and then the facts are not what the public expected? Pandemonium. Welcome to the aftermath of the “Brexit” vote.
Brexit, of course, refers to the referendum in the United Kingdom to leave the European Union (EU). Unexpected by most, the United Kingdom voted “Yes” to leaving. Stocks around the world reacted sharply. In Italy stocks fell over 10% on the news. France and Japan both closed nearly 8% lower. German stock prices stumbled and so did those of the United Kingdom. The U.S. markets felt the global pull as well and the Dow Jones Industrial Average fell over 600 points on Friday with the S&P 500 down 3.5%.
What should an investor do now? In the face of panic there are almost always opportunities. This is the case again today and we have a special study titled “Opportunities from Brexit” which covers this subject. In general, the U.S. will continue to do business with both the United Kingdom and the EU. Furthermore, there is a 2-year process for the United Kingdom and the EU to come to new trading terms, thus, neither side has a need for rash actions. Finally, as the United Kingdom exports nearly $200 billion to the rest of the EU, both groups have a vested interest in an amiable agreement.
Some analysts are concerned stocks did not bottom with a big move on Friday. Their concern is investors will panic even further over the weekend without a reliable outlet for trading and Monday will see an even greater rout. We remember the Black Monday crash in October 1987, but history suggests it is not the norm. We wanted to look at troublesome Fridays and we went back to 1960 in search of them. We scoured 2,842 Fridays and only found 8 of them with declines of 3.5% or more. While volatility often ensued, the markets typically returned to their pre Friday levels in just over 6 weeks.
Of course we do have concerns about the U.S stock market. Even with Friday’s setback most long term valuation levels, like Cyclically Adjusted Price-to-Earnings are elevated. Further, the rise in the number of regulators continues. Regulators are important and they often help protect our physical and financial wellbeing. However, when there are too many regulators they can move beyond the necessary to creating Byzantine rules. Stocks notice this. Since 2006, when the number of regulators was rising, the S&P 500 typically fell at a 5.4% annualized rate.
In spite of some international panic, our leading stock indicators are favorable. Worldwide, investors have built up very heavy cash positions, which could be reversed with lower prices. Given the turmoil from Brexit this appears to be a keen opportunity to buy select issues. We would add equities for underinvested accounts.
David W. James, CFA
Bond Market Analysis
Treasuries spent most of the week selling off and then Brexit hit and caused a major course correction. The 10-Year Treasury bond yield hit its lowest level since 2012 as investors worldwide rushed for the relatively safe confines of U.S. bonds.
What are investors to make of this? As we discuss in our special study, “Opportunities from Brexit”, we are seeing snap decisions with powerful aftershocks. While the Brexit tantrum may continue for a while, it is unlikely to have staying power and will likely reverse for a period of time.
Since we expect a reversal, this big move provides an opportunity to trim some longer term bonds. However, we don’t think it wise to abandon bonds. Once the deck is cleared, bonds will once again follow fundamentals and take their cues from the direction of the economy. Of course, if trade wars ensue, the European and global economy would suffer.
Focusing closer to home, U.S. economic news last week was lackluster. New home sales were off 6% and the Chicago Fed National Activity Index fell for the 8th time in the last 10 months. Not good. Another disquieting sign comes from the Conference Board’s Coincident-to-Lagging Index. Our research team finds this index often forecasts the future of the economy quite well. Regrettably, the index posted its worst reading since 1961.
Another key indicator is Capital Goods. Capital Goods, once volatile components like aircraft and defense are factored out, are often an excellent proxy for business investment. This is key as businesses usually need to ramp up when they expect business to increase. Against Wall Street expectations of 0.4% growth, the reality was a disappointing decline of 0.7%. Worse, this is not just a one-off. Capital Goods orders are off their levels from five years ago.
Altogether Brexit has pushed the bond market too far and too fast. It has caused our bond indicators to shift unfavorably in the intermediate term and suggests taking some profits. However, this is likely a temporary situation. The bond market will eventually return to normal and this should give another buying opportunity. For now, we would lower durations for overextended accounts.
David W. James, CFA
