Dec 16, 2014 - Here's what happened in the stock/bond markets last week

Stock Market Analysis

Stocks took a thumping last week. The Dow plunged 3.69% while the small cap Russell 2000 did slightly better, losing 2.5%. These results do not need much confirmation, but we did see almost 4 stocks decline for every one that rose in price. We are also starting to find more stocks hitting 52 week lows than new highs. We had previously pointed out that we had a hidden bear market under way for some time, with 6 of 10 small cap stocks down 20% or more from recent highs. This had not been reflected in large cap stocks, but they usually have their own problems after small caps have given up the ghost.

I had one friend ask me why I thought the Dow was falling when oil prices were falling. He thought this would be good for corporate earnings and stock prices. I replied, “There may be a couple of reasons, but no real answer. First, a good part of the Dow consists of two big Oil companies – Exxon and Chevron. Their price drops hurt the Dow. Second, lower oil prices may reflect a stronger dollar and also a worldwide slowdown in economic growth – both of which would hurt companies with large overseas operations – which all Dow components have. Lastly, it may have nothing to do with the recent pullback, a pullback was due and we are seeing a natural increase in volatility as the Fed is no longer pumping money into the system.”

As I pointed out a few weeks ago, the market isn’t cheap. This may well be a reason the market has been vulnerable to the oil shock. Last week oil prices fell over 12% but other economic reports were not scary. The National Federation of Independent Businesses showed increased optimism. Consumer confidence also took a big jump and Producer Prices remained in check. Other reports were also sanguine.

Our intermediate term indicators remain neutral and last week’s downturn may provide some good opportunities to buy undervalued stocks in underinvested accounts.

Barry R. James, CFA, CIC

We completed our Economic Outlook for 2015 and it is available in hard copy or at the following website: http://jir-inc.com/images/outlook_2015.pdf

Bond Market Analysis

It was a great week for bonds. Long-term Treasuries gained a whopping 3.6% and are up almost 25% for the year. Long-term high grade corporates rose 2.6% for the week but high yield bonds actually fell 2.1% and are up less than 1% for the year. While high yield bonds often reflect stock moves more than interest rate moves, this downturn was double barreled. Yes, stocks fell last week, but high yield indices are full of energy related bonds, and the decline in oil prices have some investors worried about getting repaid.

2014 has been the Year of the Bond, as we have pointed out many times. Many are worried about low yields on bonds, and this is a concern. We have looked back through history and the return on 10 year bonds has closely matched the starting yield at the beginning of the 10 years. If this holds true, then a yield on the 10-year Treasury bond of less than 2.5% is of small comfort. There are still good reasons to hold bonds, but a buy-and-hold approach is not likely to do well in this environment.

The first reason to hold some bonds is they reduce volatility. We did a study going back to 1947. The data suggests that having a portfolio with half bonds and half stocks, as opposed to all stocks, reduced the chances of losing 10% or more in a given year by almost a third. At the same time, it did not reduce the number of times the portfolio would have had double-digit returns. The second reason for having some bonds is obvious; they provide income payments on a regular basis. Third, they usually provide a good defense if a major crisis unfolds.

We looked back to the 70’s, when Nixon removed the United States from the gold standard. After these major crises, long-term Treasuries had double-digit returns over the next 12 months. They provide a place of refuge in a tumultuous world. Lastly, with active management, they can provide opportunities for capital appreciation. As pointed out earlier, long Treasuries have had returns close to 25% this year, while the Dow Jones Industrials Average is up less than 7%.

Looking ahead, bonds do not usually have great back to back years. So we should not expect incredible returns in 2015. The Federal Reserve has made it clear they anticipate raising short term rates over the next few years. However, lower oil prices, weak commodity prices and a strong dollar all point to modest inflation and a reasonable environment for holding bonds. Our long-term and short-term indicators are positive but our intermediate-term indicators are only neutral. In this environment, a good position in high quality bonds is not very risky, but we do not want to be overly long in our durations. Bonds continue to offer investors diversification and defense against stock volatility.

Barry R. James, CFA, CIC