Stock Market Analysis
The market declined last week with the large cap S&P 500 off 0.03 percent and the smaller stocks of the Russell 2000 down 1.67%. On a broader scale we note almost three stocks declined for every two that advanced. Non-Cyclical and Utilities fared the best on a sector level while Basic Material and Industrials fell the most.
Much of the decline occurred on Wednesday following the Federal Reserve meeting. Not only did they raise rates by a quarter percent, they also proclaimed their intension for three hikes in 2017. Of course investors should take these intentions with a grain of salt as the FED made a similar claim last year about 2016. Instead of proclamations, investors will be better served by following the data.
We have some concerns for the economy. Perhaps the best monthly gauge of the economy is Industrial Production. On a year-over-year basis it has been negative for the last 15 consecutive months. Single-family housing starts fell by slightly over 4% and apartments (units for 5+ families) declined by over 40% from a month ago.
However, the market is mostly focused on expectation or “hope” for the future. The Philadelphia Fed Manufacturing report shows this. When manufacturers in the Philadelphia region were asked about their new orders, 31.6% said orders were increasing with 17.6% responding their orders were declining. When the question was changed to business expectations for the next six months, the response was 55.2% vs. 3.7%. Nor is this just Philadelphia phenomenon; small business owners across the nation have turned bullish on the economy for the first time in over 20 months.
One area favoring stocks not based on hope is the inflation differential. Although the absolute level and direction of inflation is typically a concern for bond holders, there is information to be gleaned for stock holders as well.
Often, the Producer Price Index (PPI), on a year-over-year basis, can act as a proxy for business costs. The Consumer Price Index (CPI), also on a year-over-year basis, offers insight on companies’ ability to raise prices to their customers. When the PPI is running at a faster relative rate it suggests costs are overrunning pricing power. Since 1993 when this has occurred stocks have averaged a miniscule return of 1.3% in the next six months. When the CPI is leading, as it is now, profit margins are in better shape and stocks average a future six month return of 6.5%.
Presently our leading stock indicators have deteriorated slightly since the election and are more in the neutral camp today. This does not suggest selling now. Rather it acknowledges some of the market move and acknowledges risks are growing somewhat. At some future point we may see an excess of “hope” and it may suggest lowering equity levels at that time. We continue to recommend investors maintain a moderate position in equities with a focus on bargain and smaller sized securities.
David W. James, CFA
Bond Market Analysis
The rout in the bond market continued as the Bloomberg U.S. Intermediate Government Index fell 0.55%. The yield on the 10-Year Treasury increased from 2.47% to 2.59% on the week; up 0.7% since the November election. Long U.S. Government bonds continue to disappoint after being up 14.6% in the first three quarters of 2016. They are now down 0.85% year-to-date. The U.S. Dollar continued to strengthen, as it gained 1.25%.
The big news for the week was the FED’s decision to raise rates a quarter point for the first time this year and the second time in 10 years. FED Chairwoman Janet Yellen indicated the progress in the economy gave them confidence to raise rates. They even hinted at the possibility of raising rates three times in 2017 based on stronger economic data. These increases will likely center on the economic policies of President-Elect Donald Trump and the trajectory of economic growth.
One headwind for bond investors since September has been the increase in inflation expectations. One measure of inflation expectations is the breakeven spread between inflation linked securities and the nominal yield on U.S. Treasury bonds of similar maturities. The current spread on the 10 year notes hit a two year high last week and is about 0.5% higher than mid-year. The possibility of fiscal stimulus and increased economic growth has sent inflation expectations higher, while at the same time upsetting bond investors.
The Producer Price Index (PPI), a measure of wholesale prices, gained in November and is up 0.5% in the last 12 months. Consumer prices also increased for the month as the Consumer Price Index (CPI) is up 1.7% from this time a year ago. Both measures are well off historical norms, but they are both trending higher and at the highest levels in two years. This would suggest we do not have runaway inflation, which could give the FED time to gradually increase rates in the future.
As bond prices fall we have seen significant declines in bond sentiment as investors turn pessimistic. The report from the Commitment of Traders shows speculators are net short on the 10-Year U.S. Treasury note. The net short position is the highest since 2010. This build-up in pessimism along with the negative headlines for bonds is promising for contrarian investors, as this could suggest a rally for bonds is building.
Our intermediate bond indicators are shifting back towards the neutral camp. This is not surprising to see some of our indicators improve given the massive selloff in bonds. For now, we recommend investors focus on shorter maturities (duration) where appropriate.
Trent Dysert, CFA
Brian Culpepper, Portfolio Manager
