Stock Market Analysis
After seven straight weeks of joyful gains the Dow finally hit a sour note. The popular index did not hit the 20,000 mark this week and instead fell almost 0.9%. Other popular indexes like the large-cap S&P 500 and small-cap Russell 2000 fell 1.1% and 1.0%, respectively. Perhaps not too much should be made of this as daily volume was only about two-thirds the normal level.
We find several pieces of good news. For the second consecutive month the FED regions of New York, Philadelphia, Kansas City, Dallas and Richmond (Virginia) are all reporting improvements in the manufacturing area. Further, after spending most of 2016 enduring declining sales on a year-over-year basis, the Census Bureau reports manufacturing and trade sales are now up over 2%, the best numbers seen since October 2014.
Unfortunately, we have some concerns as well. Valuation levels often depict whether stocks are cheap, reasonable or expensive. Most of the measures we follow (Cyclically-Adjusted PE, Market Value-to-Replacement Cost and Market Value-to-GDP) suggest stocks are expensive. This generally affects long-term stock performance, not short-term. However, it does imply the market is vulnerable to shocks and disappointments.
In the short run shifts in investor sentiment will more likely impact stock movements. Institutional investors, as surveyed by Investors Intelligence, are at their most bullish levels in years. Individual investors, according to the American Association of Individual Investors (AAII), are also highly bullish. By itself, this is ok. Market advances and higher investor optimism usually go hand-in-hand. We start to worry when investors have been optimistic but begin to scale back their enthusiasm. This is when trouble typically calls.
Presently our leading indicators are gradually shifting towards the unfavorable camp. Stocks have moved in an aggressive fashion since Election Day and it may take time to consolidate some of these gains as investors shift their focus from hope about the future to seeing what actually will get done. We would recommend investors maintain a moderate level of equities at this time and focus on bargain securities.
David W. James, CFA
Clarification:
In last week’s commentary we noted, “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%.” We should have said, “After tax corporate earnings could more than double for some companies if rates actually dropped from 35% to 15%.” While this will be true of some companies, this is not likely on a broader scale. We expect the proposed tax cut would increase economic growth and earnings. An improvement closer to 25% in after tax earnings is more probable. We apologize for any confusion from our original statement.
Bond Market Analysis
It was a good week for the U.S. bond market as all sectors had positive total returns. The yield curve flattened slightly as yields on longer term maturities generally fell more than shorter term maturities. The inflation assumption imbedded in 10-Year U.S. TIPS is currently 1.96%. The U.S. dollar declined during the week and precious metals advanced. Crude oil and natural gas prices also increased.
U.S. home prices advanced during October and have risen 5.1% over the 12 months. Cleveland, OH home prices rose a strong 1.3% during the month. Over the past year, Seattle and Portland home prices have increased over 10% but the growth rate has been slowing recently. Home prices have been rising faster than incomes for several years now and may create a pinch in consumers’ wallets.
Farm prices, on the other hand, which include crops and livestock, fell by almost 9% over the past year. Egg prices continue to hover around multi decade lows and corn and milk prices continue to fall compared to their peaks a couple of years ago. Lower prices tend to help bonds as the fixed coupon payments are able to purchase relatively more.
Consumer confidence has increased rapidly since the election. The December reading was 113.7 which is the highest reading since August 2001. However, expectations for the future contributed the most to the increase while current conditions (which tend to be more accurate in the long run) fell. Consumers are also optimistic that inflation will “remain well anchored” in the words of the U.S. Federal Reserve.
U.S. GDP expectations will likely be lowered after early reports show exports have been slowing while imports have been rising. The U.S. Trade Balance showed we imported $65 Billion dollars more goods than we exported during November. This is likely due to the strength in the U.S. dollar, which is up around 4% compared to other major currencies since Election Day. Continued strength in the U.S. dollar could help bond returns in 2017.
Our intermediate term bond indicators remain negative at this time. We would recommend slowly shifting to 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 may be opportunities to make money in bonds, but the windows will be narrow and the risks higher than in past years.
Matt Watson, CFA, CPA
