Dec 10, 2013 - The Stock and Bond Market Analyses

Stock Market Analysis

Conclusions: After falling four straight days, stocks rose valiantly on Friday, pushing the Dow above 16,000 once again. The Dow still lost 0.41% while the Russell 2000 small cap index shed 1%. The decline was confirmed in the breadth figures – twice as many stocks fell as rose in the week. In addition, we saw new lows spike. While they didn’t reach the level of new highs, this kind of reversal is often indicative of a change in direction for the market.

Prices had been going higher for months, and investors, while cautious, were optimistic. Last week we noted: “The Investors Intelligence survey reported the lowest number of bears ever in its survey. This is a contrarian bearish signal because “If there aren’t any bears, who is left to sell to?” As it turns out, there weren’t many, until the jobs report on Friday. Our advice to start reducing equities in overinvested accounts seems timely now.

This year has been one of unusual tranquility in the stock market. While it has risen dramatically, it seems volatility had left the building. We did a study and found that the biggest decline of the year was less than 6% and going back to 1930 this happens only once in every ten years. What does this imply? We will very likely see a return to much higher volatility in 2014. In other words, we should expect a significant correction in the coming months.

We have tried to take a look at the improving economic numbers and their impact on the Fed and stocks. During Quantitative Easing (creating money out of thin air and buying bonds), stocks have risen at a 23% compound annual rate of return. We also note that when QE ends, stocks have fallen at a 20% clip. When QE is active, it has been a time for IPO’s and Wall Street “darlings.” However, when it comes to an end, it is time to find less conventional choices. Our research shows “unloved” stocks, those ignored and with low Wall Street expectations do best.

Our leading intermediate term indictors are neutral. This is seasonally a good time for stocks, but their recent behavior is showing signs of being ready for a break. We may start to see equities take their cue from the Fed and the possibility of tapering. This isn’t a time to be aggressive, neither is it a time to cut levels indiscriminately. We would continue to trim in overinvested accounts or poorer performing stocks.

Barry R. James, CFA, CIC

Bond Market Analysis

Conclusions: It was a bad week for bonds. Ten year treasury yields rose 14 basis points and long term treasuries lost 1.6% in value. Rates rose across the yield curve. Every sector but high yield bonds lost money, and high yield bonds were lucky to just break even on the week.

Economic news was positive and brought the attention back to the Federal Reserve and its policy of easy money and Quantitative Easing. This last Spring they gave us pretty solid guidance about their requirements for a change in approach as they emphasized the dual mandates of Maximum Employment and Price Stability. They even spelled them out as 6.5% or lower unemployment and 2.5% or less inflation. We are now down to 7% unemployment and inflation is running well below 2%. This raises the specter of tapering once again and like many dogs, the bark is actually worse than its bite. Our research shows the last two times QE was halted, rates actually fell instead of rose.

We have been talking about the relative attractiveness of Municipal Bonds for a while now. We had seen a number of investors who had been worried about Detroit and even Illinois. This last week several issues were settled in the favor of Muni investors. A federal judge ruled that Detroit can proceed with its bankruptcy filing, which protects bond holders over lower priority creditors. Illinois attempted to correct its underfunded pension with cuts in benefits, which may not be earth-shattering, but it does start to address a real worry. All of this adds to the allure of municipal bonds, since they are trading with yields above treasuries, in spite of the fact that tax rates rose this year. For those looking for bond bargains, Christmas may have come early, and in this case it could potentially be a green one. (Batteries included).

We are going through a transition period in bonds, and eventually the great 30 year bull market for bonds will be put to rest. However, this doesn’t mean bonds should be avoided. There are actually plenty of reasons to still hold bonds, but managing them wisely will be key. First, they will still provide a cushion in periods of stock market volatility, and mark my words, we will see it in 2014. Second, they will outperform in periods of economic weakness. Lastly, they still provide liquidity and income that other investments can’t match.

Our indicators are slightly favorable, which may be a reflection of the oversold nature of the market today. Deeply underinvested bond portfolios can take advantage of the backup in rates to get more favorable yields. Overall, bond investors should focus on quality bonds, diversify among the various sectors, maintain a modest duration and keep a good cushion of cash to reduce volatility.

Barry R. James, CFA, CIC